AQA A-Level Economics

MICROECONOMICS
STUDENT COMPANION

Authors: Cathy Williams and Geoff Riley

Series Editor: Ruth Tarrant

EDITION DATE: SEPTEMBER 2019

WWW.TUTOR2U.NET/ECONOMICS
COMPANION CONTENTS

4.1.1.1 Economic methodology ......................................................................................................... 4

4.1.1.2 The nature and purpose of economic activity ................................................................... 6
4.1.1.3 Economic resources ................................................................................................................ 7
4.1.1.4 Scarcity, choice and the allocation of resources ............................................................. 10
4.1.1.5 Production possibility diagrams ......................................................................................... 12
Numerical Skill 1 – using index numbers ..................................................................................... 17
4.1.2.1 Consumer behaviour ........................................................................................................... 20
4.1.2.2 Imperfect Information ......................................................................................................... 22
4.1.2.3 Aspects of behavioural economic theory ........................................................................ 25
4.1.2.4 Behavioural economics and economic policy ................................................................ 30
4.1.3.1 The determinants of the demand for goods and services ........................................... 34
4.1.3.2 Price, income and cross elasticities of demand.............................................................. 38
4.1.3.3 The determinants of the supply of goods and services ............................................... 44
4.1.3.4 Price elasticity of supply ..................................................................................................... 49
4.1.3.5 The determination of equilibrium market prices ........................................................... 51
4.1.4.1 Production and productivity............................................................................................... 69
4.1.4.2 Specialisation, division of labour and exchange ............................................................ 71
4.1.4.3 The law of diminishing returns and returns to scale ..................................................... 74
4.1.4.4 Costs of production ........................................................................................................... 77
4.1.4.5 Economies and diseconomies of scale ............................................................................ 83
4.1.4.6 Marginal, average and total revenue ............................................................................... 90
4.1.4.7 Profit ...................................................................................................................................... 94
4.1.4.8 Technological change ......................................................................................................... 97
4.1.5.1 Market structures................................................................................................................100
4.1.5.2 The objectives of firms ......................................................................................................103
4.1.5.3 Perfect competition ...........................................................................................................113
4.1.5.5 Oligopoly ............................................................................................................................122
4.1.5.6 Monopoly and monopoly power ...................................................................................135
4.1.5.7 Price discrimination ...........................................................................................................143
4.1.5.8 The dynamics of competition and competitive market processes ...........................148

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4.1.5.9 Contestable and non-contestable markets...................................................................150
4.1.5.10 Market structure, static efficiency, dynamic efficiency and resource allocation ....154
4.1.5.11 Consumer and producer surplus ...................................................................................158
4.1.6.1 The demand for labour: marginal productivity theory ................................................162
4.1.6.2 Influences upon the supply of labour to different markets ........................................167
4.1.6.4 The determination of relative wage rates and levels of employment in imperfectly
competitive labour markets .........................................................................................................173
4.1.6.5 The influence of trade unions in determining wages and levels of employment ..175
4.1.6.6 The national minimum wage ...........................................................................................180
4.1.6.7 Discrimination in the labour market ...............................................................................183
4.1.7.1 The distribution of income and wealth...........................................................................192
4.1.7.2 The problem of poverty ...................................................................................................197
4.1.7.3 Government policies to alleviate poverty and to influence the distribution of income
and wealth.......................................................................................................................................198
4.1.8.1 How markets and prices allocate resources ..................................................................200
4.1.8.2 The meaning of market failure ........................................................................................205
4.1.8.3 Public goods, private goods and quasi-public goods ................................................206
4.1.8.4 Positive and negative externalities in consumption and production .......................210
4.1.8.5 Merit and demerit goods .................................................................................................219
4.1.8.6 Market imperfections ........................................................................................................221
4.1.8.7 Competition policy ............................................................................................................226
4.1.8.8 Public ownership, privatisation, regulation and deregulation of markets ..............228
4.1.8.9 Government intervention in markets .............................................................................236
4.1.8.10 Government failure ..........................................................................................................250

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4.1.1.1 Economic methodology

Key specification content

• Economics as a social science
• How economists think and how this differs from other forms of scientific enquiry.
• How economists tackle the problems posed by complex social interactions.
• Some statements are positive and some are normative
• Decisions are influenced by value judgements and moral and political perspectives.

Models in Economics
Economists develop models and theories to help explain the multiple choices we make in our daily lives. These
models are built on assumptions that can help to simplify analysis, and allow us to think about links between
one variable and another. However, many of the assumptions that economists make risk being criticised for
not being sufficiently realistic – the real world is far more complex than most economic models suggest.

What are assumptions?

• Assumptions are initial or prior conditions made before a micro or macroeconomic analysis is built.
• Sometimes assumptions are used for simplification of a theoretical idea or an economic relationship
Ceteris paribus assumption
To simplify analysis, economists isolate the relationship between two variables by assuming ceteris paribus –
i.e. all other influencing factors are held constant. For example, “an increase in real income will cause an
increase in demand, ceteris paribus.” Here we keep constant all other factors that might lead to a change in
demand for a product.

Other assumptions
Most of the economics that we study is based on a “neo-classical” approach. Neo-classical economists make
a number of key assumptions in their analysis, including:

• people are rational;

• people (e.g. workers, business owners etc) aim to maximise their “utility” i.e. their ‘satisfaction’. For
businesses, this means aiming to maximise their profit;
• people act independently of each other when making their decisions;
• the information needed to make decisions is always accurate and complete.

Examiner Tip

Try to note down at least one assumption when you are writing analysis points in exam answers. This then
allows you to critique and evaluate your analysis later in the answer by simply questioning the assumptions
that have made. For example:

“An increase in real income should cause an increase in demand for products, assuming that they are normal
goods and have a positive income elasticity of demand. However, some goods and services are classified as
inferior goods and have a negative income elasticity of demand, so demand for them will fall when income
rises.”

Positive Statements

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Positive statements are objective statements that can be tested, amended or rejected by referring to the
available evidence. Positive economics deals with objective explanation and the testing and rejection of
theories. For example:
• If the government raises the tax on beer, this will then lead to a fall in profits of brewers.
• A fall in the cost of generating solar energy may cause a contraction of demand for coal
• A reduction in income tax will improve the incentives of the unemployed to find work.
• Higher mortgage interest rates will eventually reduce the average level of house prices

Normative Statements
Normative statements are subjective statements – i.e. they carry value judgements. For example:
• High unemployment is more harmful to a country such as the UK than high rates of inflation
• The retirement age in Britain should be raised to 70 to combat the effects of an ageing
population.
• Scarce resources are best allocated by allowing the price mechanism to work without any
intervention
• The government should enforce a minimum price for beers and lagers sold in supermarkets and
off-licences to help control alcohol consumption and reduce the number of pubs that are closing
The role of value judgements
Most economic decisions and policy are influenced by “value judgements”. These vary from person to person,
from company to company, from government to government, and from country to country. Value judgements
help us to explain why economic policies vary from place to place, and from time to time.

Examiner Tip

Deciding whether a statement is positive or normative is a common multiple-choice question. Examiners may
include words such as ‘should’ in statements that are actually positive (this is done to make students think that
they are normative). The rule-of-thumb is that students should always consider whether the statement can be
tested. If it can be tested, then it is a positive statement. It is important to remember that positive statements
can be incorrect – they can still be tested, therefore they are regarded as “positive”.

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4.1.1.2 The nature and purpose of economic activity

Key specification content

• The central purpose of economic activity is to produce goods and services to satisfy wants and
needs.
• The key economic decisions are: what to produce, how to produce, and who is to benefit from
the goods and services produced

It is often said that the main purpose of economic activity is the production of goods and services to satisfy
the ever-changing needs and wants of consumers. Economics is concerned with converting inputs to outputs;
in other words, the resources that we need to use to be able to produce the goods and services that we want.
In order to do this, some key questions have to be answered such as:

• What goods and services to produce? Does the economy use its resources to build more hospitals, roads,
schools or luxury hotels? Can the National Health Service afford free IVF treatment for childless couples
or offer new but expensive cancer treatments? How should we source our energy in the years to come?
• How best to produce goods and services? What is the best use of our scarce resources? Should
government land be sold off to provide more land for affordable housing? Should we subsidize the electric
vehicles as a strategy to reduce carbon emissions from transport?
• Who is to receive goods and services? Who will get hospital treatment - and who not? Which areas get
the go-ahead for major transport infrastructure projects such as CrossRail, HS2 and HS3 and which regions
might miss out?

Quick question

Can you think of five more economic questions, similar to those shown above?

The difference between needs and wants

A ‘need’ something that you must have in order to live and survive i.e. necessities. A ‘want’ is something that
you would like to have, but is not essential for survival. In economies at different stages of development,
households might have very different views on the differences between wants and needs i.e. classifying some
goods/services as needs or wants can be normative.

Economics is concerned with how resources are best allocated in order to satisfy needs and wants – deciding
whether to satisfy needs or wants is important.

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4.1.1.3 Economic resources

Key specification content

• Economists classify resources in different ways: land, labour, capital, enterprise (factors of
production)
• The environment is a scarce resource

Factors of Production
Economists call inputs into the production process “factors of production”. The four main categories of factors
of production are land, labour, capital and enterprise (also known as entrepreneurship). You can remember
the four main categories by using the acronym CELL.

Land Labour Capital Enterprise

• Land: the stock of natural (environmental) factor resources available for production. Remember that
this is any natural resource so this could, for example, include the sea or oil.
• Labour: the quantity and quality of the human input into the production process.
• Capital: goods made by people that are used to supply other products e.g. machines, technology,
factories, plant and software.
• Enterprise: entrepreneurs organise factors of production and also take risks when seeking to exploit
market opportunities.
What are capital goods?
These are goods that are used to make consumer goods and services. Capital inputs include plant and
machinery, hardware, software, new factories and other buildings. Capital also includes working capital e.g.
stocks of finished products and component parts (intermediate products).

What is automation?
Automation is a production technique that uses capital machinery / technology to replace or enhance human
labour. Replacing labour is known as capital-labour substitution. There have been many recent examples, for
example robots in Amazon warehouses and grocery suppliers such as Ocado, that carry out “picking and
packing”.

Working capital Transport Bulky units of Digital platforms Servers for cloud Air traffic control
Infrastructure capital enables such as computing systems
mass production Instagram networks
to happen

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Common error alert!

Many students struggle with the concept of ‘capital’ in economics, especially in relation to the term ‘investment’
(which you will also meet in your macroeconomics).

Investment, for an economist, is the purchase of capital, or the addition to an economy’s capital stock.
Investment is not about saving money in a bank or buying shares/stocks. The term is often used in a different
way in the media, so do be careful!

Quick question

Think about a business that you are familiar with (e.g. a coffee shop, a clothes shop, car manufacturer etc).
Can you think of 5 examples of each type of factor of production in that business?

Renewable and non-renewable resources

Non-renewable (finite)
Renewable resources
resources

Resources can also be categorised according to whether they are renewable or not.

What are non-renewable resources?

• Non-renewable resources are finite in supply

• With crude oil, coal, natural gas and other fossil fuels, no mechanisms exist at present to replenish
them at a rate that is faster than the rate of consumption
• The rate of extraction of finite resources depends in part on the current market price

What are renewable resources?

• Renewables are replaceable if the rate of extraction is less than the natural rate at which a resource
renews
• Examples of renewable resources are solar energy, tidal power, oxygen, biomass, fish stocks and
forestry

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Renewable electricity generation from 2000 to 2017 in the United Kingdom, by fuel (in gigawatt hours)

Hydro (large scale) Hydro (small scale) Bioenergy Solar photovoltaics

Wind (onshore) Wind (offshore) Wave and tidal
35000
Generation in gigawatt hours

30000
25000
20000
15000
10000
5000
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

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4.1.1.4 Scarcity, choice and the allocation of resources

Key specification content:

• The fundamental economic problem of scarcity – where there are unlimited wants and finite
resources, meaning that choices must be made
• The importance of opportunity costs to economic agents

What is the basic economic problem?

The basic economic problem is about scarcity and choice i.e. economics is about coming up with ways to
meet infinite wants when faced with finite resources. Each society must decide how it wishes to do this.

Scarcity
We are always uncovering new wants and needs. Because of scarcity / finite resources, all consumers,
businesses and governments must make choices. For example, five million people travel into London each
day, they make decisions about when to travel & whether to use the bus, tube, walk or cycle or work from
home.

Quick question

Note down five economic choices that you have made already today.

Emerging technologies might be changing our perception of scarcity, for example open access to the internet
& freely-available services such as Google, Twitter, Instagram & Facebook. These services are free to use but
there is an opportunity cost involved (i.e. what else we could have been doing with our time) – for example
the productive hours lost when people become addicted to social media on a daily basis.

Opportunity Cost
In economics, there is no such thing as a free lunch. Even if we are not asked to pay money for something,
scarce resources are normally used up in production and there is an opportunity cost involved. Opportunity
costs describe the unavoidable trade-offs in the presence of scarcity: satisfying one objective more means
satisfying other objectives less. In short, opportunity cost is the “cost of the alternative that is given up /
foregone, when a choice is made”

• Work-leisure choices: The opportunity cost of deciding not to work an extra 10 hours is the lost wages
foregone. If you are being paid £8 per hour to work in a shop, if you take a day off you could lose £80
of income before tax.
• Government spending priorities: The opportunity cost of the government spending nearly £10 billion on
investment in National Health Service might be that £10 billion less is available for spending on education
or improvements to the road and rail transport network.
• Investing today for consumption tomorrow: The opportunity cost of an economy investing resources in
capital goods is the production of consumer goods given up for today. Conversely, the opportunity cost
of an economy investing more in capital goods today is the production of consumer goods – living
standards may fall in the short term in order to allow long term living standards to rise.
• Making use of scarce farming land: The opportunity cost of using farmland to grow wheat for bio-fuel
means that there is less wheat available for food production causing food prices to rise and increasing the
risks of food poverty and malnutrition for world’s most vulnerable people.

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 Examiner tip:

Students frequently use the concept of opportunity cost as part of their evaluation – but you won’t get
much credit for it unless you give a sensible application of what might have been ‘given up’. For example,
it is better to write “Should the government choose to increase spending on higher education, then the
opportunity cost may be that there is less money available to spend on primary or secondary education,
assuming that the government doesn’t borrow more” than writing “Should the government choose to
increase spending on higher education then there might be an opportunity cost”.

Quick question

What is the likely opportunity cost of you choosing to study A-level Economics?

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4.1.1.5 Production possibility diagrams

Key specification content:

• Production possibility diagrams can be used to illustrate different features of the fundamental
economic problem such as:
o Resource allocation
o Opportunity cost and trade-offs
o Unemployment
o Economic growth
• All points on the boundary are productively efficient but they are not all allocatively efficient.
• Using production possibility diagrams to illustrate these features.

What is a production possibility diagram?

We usually use production possibility diagrams (or production possibility frontiers - PPFs) to show the
maximum potential output combinations of two goods that an economy can achieve when all its resources
are fully and efficiently employed. We can also use them to show the maximum potential output combinations
of two goods that a firm can achieve, when it uses all of its resources (i.e. “factors of production”) efficiently.

PPF’s are drawn like this:

• We normally draw a PPF as concave to the origin (in other words, bowed outwards)
• This is because when we move down along the PPF, as more resources are allocated towards
Consumer Goods (on the macroeconomic version) or Good X (on the microeconomic version), then
the extra output as we lose production of Capital Goods/Good Y, gets smaller – you can see this on
the following PPF diagram:

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This occurs because not all factor inputs (such as land and labour) are equally suited to producing different
goods and services leading to lower productivity. Initially, firms will move workers (and other factors of
production) towards producing Good X if the firm thinks that the workers will be really good at producing
Good X (i.e. they have the ‘right’ skills for the job). As output of Good X rises, though, firms will have to resort
to moving workers to production of Good X even if they are better suited to producing Good Y.

Examiner tip

Explaining the shape of a PPF might be a multiple-choice question, but many students struggle to gain the
marks because it is such a small part of the syllabus covered so early in the course that they have simply
forgotten it! Always make sure that you review the topics you covered early in the course.

The PPF and economic efficiency

Any point on the PPF represents a productively efficient allocation of scarce resources – all factors of
production are being used in their most efficient way. Points inside the PPF represent an inefficient allocation
of resources since it is possible to produce more of one good without sacrificing any of the other. This is
illustrated on the diagram below, which shows a PPF for a small farm, which can grow just potatoes and
carrots.

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Combinations of goods lying inside the PPF happen when there are unemployed resources or when resources
are used inefficiently. This is the case with combinations E and F.
Combinations beyond the PPF are unattainable. A country or firm would require an increase in factor
resources, an increase in productivity or an improvement in technology to reach this combination i.e. they
would need more factors of production. Combination D is unattainable on this farm at the moment.
Specialisation, trade and exchange between countries allows nations to consume beyond their own PPF. You
will cover trade and efficiency in more detail later in the syllabus.

The PPF and Opportunity Cost

Reallocating resources from producing one good to producing a different good will involve an opportunity
cost.

If we increase our output of cotton (i.e. moving along the PPF from point A to point B) fewer resources are
available to produce wheat – there is an opportunity cost of 40 tonnes of wheat.

Because the PPF is concave, this means that the opportunity cost of expanding output of cotton measured in
terms of lost units of wheat is increasing i.e. each extra tonne of cotton that we produce, we give up even
more wheat.

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Shifts in the PPF

A PPF will shift outwards if the firm, or economy, gains more factors of production, or the quality of those
factors of production improves (e.g. the economy has the same number of workers but they have received
more training and education, so are more productive). If we draw a macroeconomic PPF and it shifts outwards,
then we can say that there is economic growth.

A straight line PPF is an indication of perfect substitutability of resources such as labour or capital – we
sometimes make this assumption to make our analysis look a little tidier. Examples are given below. In the PPF
on the left, the economy has experienced an improvement in the technology available for producing capital
goods but not consumer goods – there is growth but it is not ‘balanced’, as the economy’s PPF moves from
A to B. In the PPF on the right, the economy has experienced an increase in the factors of production available
to make all types of goods – there is ‘balanced growth’ as the PPF moves from A to C.

Cause of an outward shift in the PPF Brief comment on the cause of the shift in
the PPF
Higher productivity / efficiency of factor This increases the output per unit of an input
inputs used in production
Better management of factor inputs Improved management reduces waste and
also improves quality
Increase in the stock of capital and labour e.g. from inward labour migration /
supply increased capital investment
Innovation and invention of new products Improved production processes help to lift
and resources efficiency
Discovery / extraction of new natural Discovery of commercially viable land drives
resources (land) extraction

Inwards shifts of a production possibility frontier

This is caused by a fall in the productive potential of a country i.e. something that causes a decrease in the
factors of production. This could perhaps be due to:
1. The damaging effects of severe natural disasters such as a tsunami, floods, persistent drought and
other extreme weather events

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 2. The economic damage caused by war and other types of conflict for example in failing states
3. Large scale net migration of people out of a country e.g. when there is very high unemployment
4. A long-term fall in productivity of labour

Human Capital Flight Capital Scrapping Natural Disasters Deforestation

Resource depletion
This is a decline in the total stock of resources available, for example arising in the long run from the effects
of de-population, climate change and low rates of investment in new capital inputs.

Machinery Skills Decline Buildings Basic Infrastructure

Resource depreciation
This is when the productivity / efficiency of resources diminishes with age and also with repeated use when
producing goods and services.

Examiner tip:

Questions relating to the short-run and long-run impacts on PPFs of an economy producing more capital
goods are reasonably common. In the short-run, there will be a movement along the PPF so that more
capital goods are produced and fewer consumer goods are given up. However, in the long-run, the
economy now has more capital goods and so can produce more of everything – this causes a shift outwards
of the PPF. PPFs can also be used to good effect in some analysis questions. Drawing on material from
the start of the syllabus in the final exams shows an excellent synoptic knowledge.

Quick question

What reasons can you think of that might explain why an economy would be operating at a point inside
its PPF?

Quick question

What possible policies could a government introduce to try and shift its economy’s PPF outwards?

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Numerical Skill 1 – using index numbers

Key specification content:

You are expected to be able to calculate and interpret index numbers

What is an index number?

An index number is a simple statistical technique for helping economists to interpret, analyse and compare
large numbers. These numbers might be in the form of time-series data or inter-country comparisons/ In A
level exams, you may be asked to:
• calculate index numbers
• interpret index numbers from a table or graph
Index numbers compare a current year’s data to a ‘base year’. Economists can choose any base year that they
like. In a base year, the original data is ‘equated’ to a value of 100. In the table below, the base year is shown
in the title, and the red circle indicates the base period on the graph.

UK - output per hour

2007 Q1 = 100
105.0
100.0
95.0
90.0
85.0
80.0
75.0
70.0
65.0
60.0
1994 Q2
1995 Q1
1995 Q4
1996 Q3
1997 Q2
1998 Q1
1998 Q4
1999 Q3
2000 Q2
2001 Q1
2001 Q4
2002 Q3
2003 Q2
2004 Q1
2004 Q4
2005 Q3
2006 Q2
2007 Q1
2007 Q4
2008 Q3
2009 Q2
2010 Q1
2010 Q4
2011 Q3
2012 Q2
2013 Q1
2013 Q4
2014 Q3
2015 Q2
2016 Q1
2016 Q4
2017 Q3
2018 Q2

• The chart shows that UK productivity in 1994 Q2 was about 77% of what it was in 2007 Q1
• At the end of 2018, UK productivity was only about 2% higher than it was in 2007 Q1

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The following data shows how we can use index numbers to help with country comparisons. Notes on how to
interpret the blue circled section are given below the chart.

Total investment in selected G7 countries

(2008 Q1 = 100)
115

110

105

100

95

90

85

80

75
Q1 2008
Q2 2008
Q3 2008
Q4 2008
Q1 2009
Q2 2009
Q3 2009
Q4 2009
Q1 2010
Q2 2010
Q3 2010
Q4 2010
Q1 2011
Q2 2011
Q3 2011
Q4 2011
Q1 2012
Q2 2012
Q3 2012
Q4 2012
Q1 2013
Q2 2013
Q3 2013
Q4 2013
Q1 2014
Q2 2014
Q3 2014
Q4 2014
Q1 2015
Q2 2015
Q3 2015
Q4 2015
Q1 2016
Q2 2016
Q3 2016
Q4 2016
Q1 2017
Q2 2017
Germany Japan United Kingdom United States

• In 2012, Germany’s level of investment was back to its 2008 level

• The level of investment in the UK was only 90% of its 2008 level i.e. 10 percentage points lower
• Investment in the US was around 94.5% of what it had been in 2008…but remember, there may still
have been more investment IN TOTAL in the US than Germany

As well as using base years, we can also set up index numbers in relation to base countries. This chart shows
an index of GDP per worker for a selection of advanced, high-income countries in 2015. The level of
productivity for the UK is taken as the base value, hence – UK = 100 on the chart.

GDP per worker employed

160.0
138.0
140.0
114.0 115.0 119.0
120.0 106.0 111.0
100.0
100.0 86.0
80.0
60.0
40.0
20.0
0.0
Japan UK(=100) Canada Germany Italy France G7 exc. UK US

Relative productivity differences can then easily be seen e.g. output per worker employed is 38% higher in the
United States than it is in the UK. But in Japan, labour productivity is 14% lower than in the UK.

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 Examiner tip:

Information is often shown in index number form and you may be asked to interpret it, perform calculations
using it or calculate index numbers from raw data. Costly, unnecessary marks are lost by candidates
unfamiliar with this essential part of the syllabus.

Quick question

Research other types of information shown in index number form and perform simple calculations such as
percentage changes.

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4.1.2.1 Consumer behaviour

Key specification content:

• Rational economic decision making and economic incentives

• Utility theory: total and marginal utility, and the hypothesis of diminishing marginal utility
• Utility maximisation
• The importance of the margin when making choices

Rational behaviour
Orthodox economic theory assumes that economic agents are rational. This means that they:

• Choose independently of one another

• Have fixed and stable preferences
• Have access to complete and accurate information on all the available alternatives
• Respond to incentives to make optimal choices

The key assumption is that people make choices to maximise the satisfaction (utility) they get from spending
their income. Furthermore, and similarly, businesses aim to maximise their profits.

Utility
Utility measures the satisfaction obtained from purchasing and consuming a product.

Total utility is the total satisfaction from a given level of consumption.

Marginal utility is the change in satisfaction from consuming an extra unit.

The hypothesis of diminishing marginal utility supposes

that beyond a certain point, the marginal utility of extra
units declines as more is consumed. On the table,
diminishing marginal utility happens with the 4th unit
where the marginal utility is 12. The 8th unit represents
the point of satiation where there is no more utility to
be gained. Not shown on the table, but any
consumption beyond this point would be negative and
would be irrational, even if the good were free.

As the marginal utility associated with the consumption

of each additional unit is falling, then the price rational
consumers will be willing to pay will also be falling. This
helps explain the downward sloping demand curve for
most goods or services.

The importance of margins

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The margin is very important in making rational economic choices. The margin means having a little bit more
or less of something.

1. Marginal benefit – is the change in total private benefit from one extra unit
2. Marginal cost – is the change in total private cost from one extra unit

Rational consumers for example are assumed to calculate the marginal cost and the marginal benefit of each
decision. In reality, these choices are subject to constraints. One such constraint is income.

Quick question

What other constraints on consumer choices can you think of?

Marginal analysis features throughout the syllabus – for example in the theory of the firm and labour market
analysis.

Utility maximisation
Consumers are assumed to attempt to maximise utility. With a single product, this will be at the point of
satiation, assuming the budget of the consumer allows this point to be reached. Economists also assume that
businesses aim to maximise their profits.

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4.1.2.2 Imperfect Information

Key specification content:

• Information is important for decision making

• When information is imperfect or asymmetric, economic agents will find it difficult to make rational
decisions and markets may fail.

What is information failure / information gaps?

• Information failure occurs when people have inaccurate, incomplete, uncertain or misunderstood
data and so make potentially ‘wrong’ or sub-optimal choices.
• From pensions to computer games consoles, from investing in the stock market to ignorance about
the consequences of borrowing and debt, all of us suffer from one or more information failures.
• The key issue is whether the information failure is trivial or instead it has a big effect on individuals,
their families and society as a whole.
• There may be a case for the government to intervene in a market in some way if information failures
become serious and persistent.

Causes of information gaps

Imperfect information can be caused by
§ Misunderstanding the true costs/benefits: e.g. the side effects of using tanning salons or painkillers
§ Uncertainty about costs and benefits e.g. should younger workers be buying into pension schemes
when we can only guess at conditions in 40 years’ time?
§ Complex information when buying specialist products
§ Inaccurate or misleading information - persuasive advertising may ‘oversell’ the benefits of a product
leading to more consumption than is optimal. Spam mail can be a cause of misinformation for
consumers.
§ Addiction e.g. drug addicts may be unable to stop consumption of harmful substances
§ Lack of awareness – a good example here is that of tuition fees in Britain – many parents and students
find the system of university finance difficult to understand
§ Habitual purchase – buying goods simply out of habit e.g. reordering the same items in an online
grocery shop because consumers are presented with their ‘favourites’ list when they log on

Examples of information gaps

In nearly every market we find examples of information gaps. Some of them are shown in the graphic below:

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 Risks from using tanning Addiction to painkillers & Gaining entry to elite Complexity of pension
salons other drugs degree courses schemes

Uncertain quality of Knowledge of the Cowboy builders or other Tourist Bazaars or buying
second hand products nutritional content of “rip-off merchants” and selling antiques
foods

Symmetric and asymmetric Information

• For markets to work, there needs to be symmetric information i.e. consumers & producers have the
same knowledge about products, they know everything there is to know about the effects of
consuming them
• Asymmetric information is when there is an imbalance in information between buyer and seller which
can distort choices

Used vehicles Insider dealing Tenants & landlords

Health insurance Borrowers and lenders Product warranties

Examples of asymmetric information include:

• Landlords who know more about their properties than tenants
o This allows landlords to extract higher rent payments from tenants
• Car insurance companies cannot tell the risks associated with selling premiums to each driver – they
have to pool risks and assign premiums to groups of drivers based on assessed risk-factors
o Some very safe drivers may pay higher insurance premiums than they really need to

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 • Some students have superior knowledge about how to get into the elite / best universities including
which prior courses to take
o This can perpetuate inequality and reduce social mobility
• Doctors have superior knowledge about drugs and treatments
o In a private healthcare system, such as that in the US, this may lead doctors to overprescribe
expensive and sometimes unnecessary treatments
• A used-car seller knows more about vehicle quality than a buyer
o The buyer may pay too much for their car
• Insider information of traders in financial markets
The impact of these gaps is that either an ‘incorrect’ amount is bought and/or the wrong price is paid.

Extension ideas: Moral Hazard and Adverse Selection

These are two important aspects of asymmetric information in insurance markets – moral hazard and adverse
selection.

Moral Hazard
• Moral hazard occurs when insured consumers are likely to take greater risks, knowing that a claim will
be paid for by their cover
• The consumer knows more about his/her intended actions than the producer (insurer)
A good example of moral hazard is the bail out of the banking system after the 2007 crash.

Adverse Selection
• The adverse selection problem is seen in health insurance
• Those most likely to purchase health insurance are those who are most likely to use it, i.e.
smokers/drinkers/those with chronic health conditions
• The health insurance company knows this and so raises the average price of insurance cover
• This may price some healthy low-risk consumers out of the market, meaning that mainly higher risk
individuals gain insurance – this causes a market failure

Quick question

Think about goods and services you have bought or used today. Are there any in which you think you may
have been affected by an information gap? If so, which goods/services, and why?

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4.1.2.3 Aspects of behavioural economic theory

Key specification content:

• Behavioural economics questions the assumption that individuals are rational maximisers
• Some of the reasons include bounded rationality and bounded self-control.
• As a result, rules of thumb are employed, resulting in biases.
• Altruism and perceptions of fairness are also important.

Use all information when People seek to maximise

making choices satisfaction

The assumption of rational behaviour

The assumption of rationality has dominated standard economic thinking and orthodox theory for decades.
However, there are many reasons why individuals may not necessarily act in a rational way:

Limited ability to Importance of social

Emotion overtakes logic
calculate networks

Altruism v pure self Desire for instant People stick to default

interest rewards choices

Economic agents in reality:

• Have limited capacity to calculate all costs and benefits

• Are influenced by their own social networks
• Often act reciprocally rather than in pure self interest
• Lack self-control and seek immediate satisfaction
• They are loss averse (losses matter more than gains)
• They make different choices in cold & emotional states

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 • Often fall back on simple rules of thumb when choosing
• Satisfice rather than maximise
• Have a strong default to maintain the status quo

Bounded rationality

Rules of thumb might

Choice does not Search costs in
Pensions are complex replace pure
always help finding the best price
rationality

• Most consumers and businesses do not have sufficient information to make fully-informed
judgements when making their decisions in markets
• The increasing complexity of products makes life difficult
• People have limited attention spans
• Many consumers and businesses opt to satisfice rather than maximise
• They will use rules of thumb and approximations when making their choices
These rules of thumb or approximations are called heuristics. Their use can lead to biases. Decisions are
biased when there are systematic errors.

Bounded self-control
This concept is closely linked to bounded rationality. According to traditional/ neo-classical theory, when a
consumer knows that the price of a good exceeds the marginal utility they gain from consuming it, then if
they are rational they will stop consuming it. There is plenty of evidence that in reality, consumers do not stop
consuming even when it makes sense. Examples include over-eating, excessive investment in a particular
stock or share and so on. One explanation is that people are myopic or shortsighted. Another phrase for this
is hyperbolic discounting when the present is given a much greater value than the future. A good example is
people’s inability to save effectively for retirement.

Social norms

Social norms are one commonly used heuristic.

Respecting seat belt laws Social norms when queuing Not smoking in public places

Social norms at the pub such

as buying a round of drinks

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Our day-to-day behaviour in markets is often strongly influenced by prevailing social norms or social customs.

Examples of social norms:

• Changing the social stigma of drink-driving and speeding
• Observing white lines in car parks
• Queuing behaviour in shops
• Impact on behaviour of smoking bans in all public places
• Making seat-belts compulsory – these created conventions which then became self-sustaining

Habitual behaviour

This is another common heuristic and is closely linked to loss aversion and default choice.

Most of us choose the Our menu choices are A default opt-in (or auto
same breakfast! predictable enrollment) e.g. for
pensions organ
donations can have a
powerful effect
• Most people carry on behaving as they have always done.
• Repeat choices / purchases often become automatic because default choices don’t involve mental
effort
• To get people to change their behaviour may require compelling incentives or introducing a form of
mandated choice (also known as a default rule)
• Examples of habitual behaviour:
o Your choice of daily breakfast cereal / razor / sandwich preference
o Many consumers of energy, broadband and banks stay with the same provider

Herd Behaviour

Closely linked to social norms is herd behaviour. Herd behaviour is very important in explaining bubbles in
asset prices. We are herd animals and we often make decisions based on who is around us plus the choices
they make
• Examples:
o Choosing items off a menu in a restaurant
o Herd behaviour in financial markets
o Binge drinkers going on holiday with each other

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 Herd behaviour is often Amazon Prime – people Ratings systems for
seen in financial markets don’t want to miss out hotels, books, general
on a deal products
Anchoring
Value is often set by anchors or imprints in our minds we use as mental reference points. Retailers are very
adept at using this “bias” to persuade consumers to spend.

• Some anchors establish in our mind a low price, others help to establish a higher basic price that we
should be prepared to pay
• Examples:
o “Big Price Drop” campaigns by supermarkets
o Refereeing decisions might be anchored by the size (and noise!) of home crowd
o Price anchors used in menus at restaurants and in coffee shops

Offer price for Pricing of new McDonalds has a

houses on sale is products such as lower anchor price
an anchor for the Apple Watch than Starbucks
potential buyers

Availability
This refers to the tendency of people to judge the likelihood of an event by the ease with which examples and
instances come easily to mind.

• Mosr consumers are poor at risk assessment and will for example over-estimate the likelihood of
attacks by sharks or accidents.
• Smokers see one elderly heavy smoker and exaggerate the likely healthy life expectancy of this group.
• Periods of very warm weather affect beliefs about the causes of climate change.

Examiner tip:

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Questioning the assumptions made in analysis is a highly effective way to evaluate. Using behavioural
economic ideas to critique the assumption that economic agents are rational and have perfect information is
therefore a fairly ‘fail-safe’ way to evaluate.

Altruism

This is the phenomenon in behavioural science for humans to behave with more kindness and fairness than
would be the case if they behaved rationally. Altruism is often linked to the concept of inequity aversion - i.e.
humans do not like highly unequal outcomes. Whilst this is usually seen as positive, it can also result in a
negative outcome - e.g. a person being willing to forego a gain / reward if it means that someone else won’t
gain an even better reward.

Loss Aversion

Closely linked to some of the heuristics above, especially inertia, is loss aversion.

Loss aversion is used extensively in marketing strategies. Marketing emphasises discounts rather than avoiding
a surcharge. Examples could include:
1. Renew a season ticket before 1st July to get a discount of £50
2. Season ticket renewed after 1st July increases in price by £50

Some policymakers have successfully used this concept to improve economic outcomes, for example, the
“Save More Tomorrow” pension plan from Nobel-winner Professor Richard Thaler
• Richard Thaler created a pension plan where investors signed up for a pension that costs nothing
until they receive a pay rise
• At which point a percentage of their pay rise would automatically be directed into their pension
fund
• By making sure the saver never saw a reduction in his disposable income, pension contributions
among this group rose 200%

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4.1.2.4 Behavioural economics and economic policy

Key specification content:

• Choice architecture and framing
• Nudges
• Default choices, restricted choice and mandated choice
• Insights provided by behavioural economists can help governments and influence economic
decision making

Choice architecture
Choice architecture describes how decisions are affected by the design/ sequencing/ range of choices
available. It is often most effective when it encourages simplicity in the decisions that people must make and
in which the benefits and costs are made clear.

Getting more people to use Traffic flow is influenced by

the salad bar at lunch road architecture

How can we encourage How best to get people to

people to avoid the lift? use hand sanitizers?

Framing – how information is presented

Framing refers to how decisions are influenced as a result of how information is presented and organised. We
may react in different ways and make different choices if the same information is simply presented in a different
way.

• Examples of framing:
o Framing of privacy settings on social networks such as Facebook
o Presumed consent for human organ donations to increase the supply of organs
o Framing of referendum questions
o Framing of interest paid on loans
o Asymmetric framing
o Involves including an obviously inferior 3rd choice or a hyper-expensive 3rd option rather
than a simple expensive/cheap choice can guide consumers to more expensively-priced
items

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 90% fat free or 10% The framing of the
fat? Which is most Greek referendum
effective in shaping ballot paper may have
spending? been important

Default choices, restricted choices and mandated choices

Mandated choice refers to a situation when people must decide in advance with respect to whether they wish
to participate in a particular action – they are required by law to make that choice. These decisions are usually
public policy decisions e.g. deciding whether to donate your organs when you die, choosing whether to make
a “living will” etc. In the UK, if you haven’t recorded an organ donation decision (opt in or opt out) on the NHS
Organ Donation Register, then you will be treated as having no objection to donating organs.

• There is often a divide between intention and action especially for people with limited resolve and
those vulnerable to temptation!
• The more public our position, the less willing we are to change it
• We feel strongly about activities where we have made a personal commitment
o Commitment contracts can reinforce decisions to adopt healthful behaviors
o They impose a penalty if people do not reach a goal – invoking loss aversion
o Conditional cash transfers (CCTs) have become popular in many poorer countries
o Examples:
§ Committing yourself to a diet using an online app
§ Commitment to joining a local savings scheme /credit union
§ Commitment signals to a partner using an expensive gift

Pre-commitment can We are more likely to Commitment apps are

cement a choice value self assembly becoming more
furniture we buy popular!

A restricted choice situation often exists because humans have bounded rationality. When faced with too
many choices and too many decisions, it can be stressful and cause indecision. Restricting the number of
choices available may, therefore, actually improve efficiency. The 2004 book “The Paradox of Choice” by Barry
Schwarz noted that:

“Autonomy and Freedom of choice are critical to our well being, and choice is critical to freedom and
autonomy. Nonetheless, though modern Americans have more choice than any group of people ever has
before, and thus, presumably, more freedom and autonomy, we don't seem to be benefiting from it
psychologically.”

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The default choice is the “choice” that is selected when you do nothing – it may feel like you are not making
a choice at all. Consumers infrequently change their ‘default’ setting. One example might be that a new
contract for broadband or a magazine subscription assumes that the default choice is for the subscription /
contract is automatically renewed every year – the only way to get a phone call or email to remind you to
renew is to have ticked the relevant box on the application form…but many consumers will not do this, and
therefore the contract / subscription will keep on rolling over.

Nudges
A nudge is something that impacts an irrational economic agent but would have no impact on someone who
is rational. A nudge is used by choice architects to change someone’s behaviour in a low-cost and easy way
(usually without changing the number of choices available), towards behaviour that is preferred by society.

Some Behavioural Economics in Action

Organ Donation and Cash incentives from “Chunking” to increase

the importance of form the NHS to help stop the rate of drug
design people smoking treatment completion

Lotteries to encourage Using simple checklists Choice architecture to

weight loss or cut in hospitals to reduce encourage healthy
speeding on roads number of x-rays eating

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 Using the aroma of Adding £160 cost of “Help your friend raise even
disinfectant gel to appointment to a text more money by sharing
encourage regular use in reminder reduced NHS their page” raised giving by
hospitals non-attenders by 25% 28%

Auto-enrolment combats Align teacher interests with

status quo bias for pensions student learning with social
rewards
Critical Evaluation: Are Behavioural Nudges Effective?
• Behavioural economics may encourage government to become too paternalistic in their policies
attempting to nudge behaviour
• Behavioural economics focuses too heavily on people’s vulnerability to fall for fallacies and their
psychological biases – it can give the impression that consumers are dumb
• In fact, consumers using well-practiced rules of thumb might be operating in a rational way
• There are clear limits to the application of nudge theory – it may be useful in changing minor
behaviours in a modest way but not in deep rooted psychological problems such as alcoholism and
street violence
• Conventional policy interventions such as taxes, subsidies and regulations are often just as effective
as nudges – although nudges may complement and work alongside conventional interventions
• Nudge theory may help change minor behaviours but may be less effective in addressing deeper
social problems such as alcoholism, drug dependence and gang violence
• Samples used in laboratory testing for psychological biases might be flawed e.g. relying on sampling
mainly white, middle class students – this is not replicable in real world
• The impacts of nudges are contextual – i.e. what works in one country might not be as effective in
another nation at different stages of economic development.

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4.1.3.1 The determinants of the demand for goods and services

Key specification content:

• The relationship between price and quantity demanded

• Factors that may cause a shift in the demand curve (the conditions of demand)

What is demand?
Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a
given time period. Effective demand is when a desire to buy a product is backed up by an ability to pay. When
economists write about ‘demand’, they usually mean ‘effective demand’.

Derived demand is the demand for a factor of production used to produce another good or service. For
example, steel - the demand for steel is linked to market demand for cars and construction of new buildings

Law of Demand
There is usually an inverse relationship between the price of a good and demand.
1. As prices fall, we see an expansion/extension of demand.
2. As prices rise, there will be a contraction of demand.

Quick question

Can you think of any products that people are more likely to buy when they are more expensive?

Ceteris paribus assumption

When drawing a demand curve, economists assume all factors are held constant except one – the price of the
product itself. Ceteris paribus is an important assumption used in nearly all economic analysis that allows us
to isolate the effect of one variable on another variable.

Demand Curve
A demand curve shows the inverse relationship between the price of an item and the quantity demanded over
a period of time. There are two reasons why more is demanded as price falls:
1. The Income Effect: When the price of a good falls, the consumer can maintain the same consumption
for less expenditure; effectively, this increases ‘real income’. Provided that the good is normal (i.e.
one for which demand rises when income rises, and demand falls when income falls), some of the
increase in real income is used to buy more.
2. The Substitution Effect: When the price of a good falls, ceteris paribus, the product is now relatively
cheaper than an alternative and some consumers will switch their spending from the alternative good
or service. The more substitutes there are in the market and the lower the cost/inconvenience of
switching, the bigger the substitution effect is likely to be.

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 This is how we draw demand curves:

It is really important to label and annotate economics diagrams correctly. You need to:
- Label the axes – in this case, price and quantity
- Label the curve – in this case, a D to stand for ‘Demand’
- Keep your numbering consistent e.g. P2 corresponds to Q2
- Keep your diagrams as tidy and clear as possible!

REMEMBER:

• As price falls, a person switches away from rival products towards the product
• As price falls, a person’s willingness and ability to buy the product increases
• As price falls, a person’s opportunity cost of purchasing the product falls
Note: Many demand curves are drawn as straight lines; this is to make the diagrams easier to draw and
interpret. In the ‘real world’ they are unlikely to be perfectly linear!

Changes in the “Conditions of Demand”

Shifts in the demand curve are due to changes in “non-price factors” i.e. anything that might affect the demand
for a good other than its prices. An increase in demand is represented by a shift to the right (an outwards
shift) of the demand curve. A decrease in demand is shown by a shift to the left (an inwards shift) of the
demand curve. Non-price factors could include:

• Changing prices of a substitute good or service (also known as goods in competitive demand)
• Changing price of complements (also known as products in joint demand)
• Changes in the real income of consumers
o When real income goes up, our ability to purchase goods and services increases, and this
causes an outward shift in the demand curve for ‘normal goods’
o When real incomes fall there will be a decrease in demand (except for inferior goods i.e.
those that we buy less of as our income rises and more as our income rises)

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 • Changes in the distribution of income - a more equal distribution of income can increase total
demand because relatively poorer consumers spend a higher proportion of their income
• The effects of advertising and marketing to alter tastes and preferences
• Interest rates (e.g. affecting the cost of credit for “big ticket items” such as a new car or home
improvements)
• Changes in the size and age structure of a population
• Seasonal factors for some goods and services
• Social and emotional factors affecting demand

You also need to know how demand for one god or service might be related to another.

Joint demand
Joint demand is when demand for one product is positively related to demand for a related good or service.
Two complements are said to be in joint demand. Examples of joint demand include: fish and chips, iron ore
and steel, apps for smartphones

Composite demand
Composite demand exists where goods have more than one use, and so an increase in the demand for one
product leads to a fall in supply of the other. An example is milk which can be used for cheese, yoghurts,
butter and other products including fertilizer. Another example is land e.g. farmland can be developed in
many different ways and urban land has different uses (houses, offices etc). Oil is used in many different
industries such as plastics

Derived demand
Derived demand is the demand for a factor of production used to produce another good or service. For
example, steel is strongly linked to the market demand for cars and construction of new buildings. In the
labour markets, the demand for labour is derived from the goods and services it will produce. An increase in
air travel will lead to a derived demand for airline pilots.

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Common error alert!

One of the most frequently seen errors by examiners is students wanting to shift the demand curve to the
right or left when there is a change in the price. It is vital that you understand that a change in the price causes
a movement along the demand curve. Only a change in non-price factors will cause a shift of the demand
curve to the right or left.

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4.1.3.2 Price, income and cross elasticities of demand

Key specification content:

• Calculate price, income and cross elasticity of demand
• The relationship between income elasticity of demand and normal and inferior goods
• The relationship between cross elasticity of demand and substitute and complementary goods
• The relationship between price elasticity of demand and total revenue (including calculation)
• Factors that influence these elasticities of demand

Price elasticity of demand

Price elasticity of demand (PED) measures responsiveness of quantity demanded after a change in the good’s
own price. The basic formula for calculating the co-efficient of price elasticity of demand is:

Percentage change in quantity demanded

Percentage change in price

All goods with downward sloping demand curves will have a negative coefficient of PED.

Examiner tip

It is important that you can use and rearrange the PED formula. You may also need to carry out % change
calculations to calculate % change in Qd and / or % change in P.

Interpreting the coefficient of price elasticity of demand

1. If PED = 0, demand is perfectly inelastic – quantity demanded does not change at all when the price
changes – the demand curve will be vertical.
2. If PED is between 0 and -1 (the % change in quantity demanded is smaller than the percentage
change in price), demand is price inelastic i.e. quantity demanded is not particularly responsive /
sensitive to price changes.
3. If PED = -1 (the % change in quantity demanded is exactly the same as the % change in price),
demand is unit price elastic. A 15% rise in price would lead to a 15% contraction in quantity demanded
leaving total spending on the good exactly the same.
4. If PED is between -1 and -∞, quantity demanded responds more than proportionately to a change in
price i.e. demand is price elastic. For example, if a 10% increase in the price of a good leads to a 30%
drop in quantity demanded, the price elasticity of demand for this price change is –3
5. If PED = -∞ then demand is perfectly elastic – quantity demanded will fall to zero if the price rises –
the demand curve will be horizontal

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Factors affecting price elasticity of demand

Availability of close Cost of switching Breadth of Degree of necessity Time frame when
substitutes suppliers definition of making a choice
product

Brand loyalty Percentage of Habitual demand

income spent on a
product

1. Number of close substitutes – the more substitutes there are in the market, the more elastic is demand
because consumers find it easy to switch. For example, air travel and train travel are weak substitutes
for inter-continental flights but closer substitutes for journeys of 200-400km between major cities.
2. Cost of switching between products – there may be costs involved in switching. In this case, demand
tends to be inelastic. For example, mobile phone service providers may require a contract that has
the effect of locking-in some consumers once a choice has been made.
3. Degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand
whereas luxuries tend to have a more elastic demand. An example of a necessity is rare-earth metals
that are an essential raw material in the manufacture of solar cells, batteries. Another example might
be essential medicines such as insulin for people with diabetes.
4. Proportion of a consumer’s income allocated to spending on the good – products that take up a high
% of income will have a more elastic demand.
5. Time period allowed following a price change – demand is more price elastic, the longer that
consumers have to respond to a price change. They have more time to search for cheaper substitutes.
6. Whether the product is subject to habitual consumption – consumers become less sensitive to the
price of the good when they buy something out of habit (it has become the “default choice”).
7. Peak and off-peak demand - demand is price inelastic at peak times and more elastic at off-peak
times – this is the case for transport services.
8. Breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or
meat, demand is often inelastic. Individual brands of petrol or beef are likely to be price elastic.
9. Method of payment – people tend to notice price changes more when they pay in cash rather than
card, or direct debit.

Examiner tip:
The best candidates use economic language and terminology with high accuracy. It is much more effective to
write that a product has price elastic demand rather than simply writing that the product has elastic demand
(because there are different types of demand elasticity). Definitely avoid writing phrases such as “petrol is
inelastic”!

Price elasticity of demand and total revenue

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Total revenue can be determined by calculating price x quantity bought. The relationship between elasticity
of demand and a firm’s total revenue is an important one often tested in exams:
• When demand is price inelastic, a rise in price leads to a rise in total revenue – for example, 20% rise
in price might cause quantity demanded to contract by only 5% (PED = -0.25). So, the rise in price is
more than proportional to the fall in quantity demanded, and so total revenue will rise.
• When demand is price elastic, a fall in price leads to a rise in total revenue - for example, a 10% fall
in price might cause quantity demanded to expand by a much larger 25% (PED = +2.5). The rise in
quantity demanded is proportionately greater than the fall in price, and so total revenue will rise.
• When demand is perfectly inelastic (i.e. PED = zero), a given price change will result in the same
revenue change, for example, a 5% increase in a firm’s prices results in a 5% increase in its total
revenue
• When demand is unit elastic (i.e. PED = -1) a change in the price leads to no change at all in the
revenue

Examiner tip:

Make sure that you can explain the relationships stated above, rather than merely repeat the relationships –
this will help you to pick up analysis (AO3) marks and not just knowledge (AO1) marks.

Quick question

Can you think of businesses that have recently a) raised their prices and b) lowered their prices? Using your
knowledge of the relationship between PED and total revenue, can you give an explanation of these business
choices?

Price elasticity of demand and total revenue – numerical example

The table below gives an example of the relationships between price, quantity demanded and total revenue.
As price falls, the total revenue initially increases, in our example the maximum revenue occurs at a price of
£12 per unit when 520 units are sold giving total revenue of £6240.

Price Quantity Total Revenue

£ Per Unit Units £
20 200 4000
18 280 5040
16 360 5760
14 440 6160
Consider the price
12 520 6240
elasticity of demand of
10 600 6000
a price change
from £20 8 680 5440 per unit to
£18 per 6 760 4560 unit.
• The % change in quantity demanded is +40% after a -10% change in price, which gives a PED of -4
(i.e. highly elastic).
• In this situation when PED is highly elastic, a fall in price leads to higher total consumer spending /
producer revenue

Now consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit.

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 • The % change in demand = 13.3% following a 20% fall in price – giving a co-efficient of elasticity of
– 0.665 (i.e. inelastic).
• A fall in price when demand is price inelastic leads to a reduction in total revenue.

What you have seen in the above table is that the price elasticity of demand changes along the demand curve.
As we move from left to right along the demand curve, PED becomes increasingly more price inelastic. This is
because we are looking at proportional changes and not absolute changes. This is illustrated in the diagram
below, which also illustrates how we can represent total revenue on a demand curve:

We can illustrate the impact of price changes on total revenue at different price elasticities of demand using
this diagrammatic approach:

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 CHANGE IN THE MARKET WHAT HAPPENS TO TOTAL REVENUE?

Ped is inelastic (<1) and a firm raises its price. Total revenue increases
Ped is elastic (>1) and a firm lowers its price. Total revenue increases

Ped is elastic (>1) and a firm raises price Total revenue decreases
Ped is unit elastic (=1) and a firm raises price Total revenue remains the same

Ped is -1.5 (elastic) and the firm raises price by 4% Total revenue decreases

Ped is -0.4 (inelastic) and the firm raises price by 30% Total revenue increases
Ped is -0.2 (inelastic) and the firm lowers price by 20% Total revenue decreases

Ped is -4.0 (elastic) and the firm lowers price by 15% Total revenue increases

Usefulness of Price Elasticity of Demand for Producers

Firms can use PED estimates to predict:

• Effect of a change in price on total revenue of sellers

• Price volatility in a market following changes in supply – this is important for commodity producers who
suffer big price and revenue shifts from one time period to another.
• Effect of a change in an indirect tax on price and quantity demanded and also whether the business is
able to pass on some or all of the tax onto the consumer.
• Information on the PED can be used by a business for price discrimination. This is where a supplier decides
to charge different prices for the same product to different segments of the market e.g. peak and off-
peak rail travel or prices charged by many of our domestic and international airlines. You will meet this
concept in more detail in Theme 3.
• Usually a business will aim to charge a higher price to consumers whose demand is price inelastic (Ped<1)
• Arguably, businesses are keen to make demand for their goods and services more price inelastic

In reality, though, it is really difficult for businesses to estimate the PED for their goods – this is because we
can only calculate it assuming that ‘ceteris paribus’ holds. In reality, many factors affect the amount of a good
or service bought, and it is difficult to ‘isolate’ the effect of a price change alone.

Income elasticity of demand (YED)

Income elasticity of demand (YED) measures the responsiveness of demand following a change in real income.
The formula used for calculating income elasticity of demand is:

Percentage change in demand divided by the percentage change in income

Normal and inferior goods

Normal goods have a positive income elasticity of demand so as consumers’ income rises, more is demanded
at each price i.e. there is an outward shift of the demand curve
Economists usually describe normal necessities as having an income elasticity of demand of between 0 and
+1 for example, if income increases by 10% and demand for fresh fruit increases by 4%, income elasticity is
+0.4. Demand is rising less than proportionately to income – demand is income inelastic

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Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than
proportionately to a change in income – for example an 8% increase in income might lead to a 10% rise in
demand for new kitchens. Income elasticity of demand in this example is +1.25. Demand is income elastic.

Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises.
Typically, inferior goods or services exist where superior goods are available if a consumer has money to be
able to buy it. Examples include demand for cigarettes, economy own label foods in supermarkets and
demand for council-owned rented properties. In the aftermath of the 2008/2009 recession experienced in the
UK, there was some surprising evidence of the goods that came to be regarded as ‘inferior’. For example, as
national income fell, there was a large increase in demand for goods such as home-delivered pizza (which
was a substitute for eating out in restaurants) and lipstick (as many women swapped more expensive spa
treatments for a little ‘pick-me-up’).

Product ranges, income elasticity and long-term trends

Income elasticity of demand will vary within a product range. For example, YED for own-label foods in
supermarkets is less for high-value “finest” food ranges. There is a general downward trend in income elasticity
of demand for many basic products, particularly foodstuffs. One reason is that as a society becomes richer,
there are changes in tastes and preferences. What might have been considered a luxury good several years
ago might now be regarded as a necessity.

Inferior goods

Own label
Urban bus transport Cigarettes Economy class travel
discounters

Own-label cereals Economy Foodstuffs

Common error alert!

Just because an economist might categorise a particular good or service as ‘inferior’ does not necessarily
mean that the good/service is poor quality – it is just less desirable than other alternatives. You must refer to
negative income elasticity of demand as the main feature of inferior goods.

How do businesses make use of estimates of income elasticity of demand?

Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle (the pattern of
boom and recession) on sales. Luxury products with high-income elasticity see greater sales volatility over a
business cycle than necessities that are income-inelastic where demand from consumers is less sensitive to
changes in the cycle.
Income elasticity and the pattern of consumer demand
As we become better off, we can afford to increase our spending on different goods and services. Income
elasticity of demand will also affect the pattern of demand over time.

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 • For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, the proportion
of a consumer’s income spent on that product will go up.
• For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods
(where income elasticity of demand is negative) – as income rises, the share or proportion of their
budget on these products will fall
• For inferior goods as income rises, demand declines and so too will the share of income spent on
inferior products. A good example of a product with a negative income elasticity of demand is
tobacco products. Many factors affect demand for cigarettes and related products including indirect
tax placed on them by the government and also the effects of health campaigns and bans on smoking
in public places.

Cross (price) elasticity of demand (XED)

Substitutes Complements

Cross elasticity of demand (XED) measures responsiveness of demand for good X following a change in the
price of good Y (a related good). With cross elasticity, we make an important distinction between substitute
products and complementary goods and services.

% change in demand for Good X

% change in price of Good Y

Substitutes:
Substitutes have a positive cross price elasticity of demand. An increase in the price of one product will lead
to a rise in demand for its substitute, as consumers swap away from the more expensive good. A high value
suggests both products are close substitutes.

Complements:
When there is a strong complementary relationship, cross elasticity will be negative. An increase in the price
of Good T will lead to a contraction in demand for T and a fall in demand for a complement, good S.

Unrelated products:
Unrelated products have zero cross price elasticity of demand

The business relevance of XED

Businesses may want to consider supplying complementary goods together in a ‘bundle’, or ensuring that
they are positioned close to each other in shops. They may also want to take advantage of what is often called
the ‘razor and blades’ model – razors are generally available to buy quite cheaply, but the accompanying
blades (sold separately) are expensive. We see this being used by printer companies, which sell printers quite
cheaply but then charge a high mark-up on the printer ink cartridges. With substitute products, we often find
that different brands are owned by the same company (“brand proliferation”) e.g. Unilever, and Procter and
Gamble, own many different cleaning product and toiletries products each.

4.1.3.3 The determinants of the supply of goods and services

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 Key specification content:
• Distinction between movements along a supply curve and shifts of a supply curve
• Factors that may cause a shift in the supply curve (the conditions of supply)
• Higher prices imply higher profits and this provides the incentive to expand production.
• In perfect competition, the supply curve is the marginal cost curve

Supply
Supply is the quantity of a good or service producers are willing and able to supply at a given price in a given
time period. The law of supply is that as price rises, so businesses expand supply. Higher prices provide a profit
incentive for firms to expand production. A supply curve shows the relationship between market price and
how much a firm is willing and able to sell. The key to understanding market supply is to be aware of the
importance of the profit motive. Suppliers will be looking to get the best price for their product. Note - supply
is not necessarily the amount sold, if consumers do not wish to buy the product, it will remain unsold.

Market supply is total supply brought to market by producers at each price. To calculate, we sum individual
supply schedules for each producer. An example is shown in the table below.

Price (£) Firm A’s supply + Firm B’s supply + Firm C’s supply + = Market Supply
10 30 0 5 35
20 45 10 15 70
30 65 20 40 125
40 100 30 70 200

Supply Curves
A supply curve is drawn assuming ceteris paribus (other factors held constant) so that if price varies, we move
along a supply curve. In the diagram that follows, as price rises from P1 to P2, there is an expansion / extension
of quantity supplied. If market price falls from P1 to P3, there is a contraction of quantity supplied. Businesses
are responding to market price signals when making output decisions.

Explaining the law of supply

There are three key reasons why supply curves are drawn as sloping upwards from left to right giving a positive
relationship between market price and quantity supplied:

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 1. Profit motive: When market price rises following an increase in demand, it becomes more profitable
for businesses to increase their output
2. Production and costs: When output expands, a firm’s production costs tend to rise; therefore, a higher
price is needed to cover these extra costs of production. This may be due to diminishing returns as
more factor inputs are added to production.
3. New entrants into the market: Higher prices may create an incentive for other businesses to enter the
market leading to an increase in total supply. (note – if businesses enter the market for any reason
other than an increase in the price of the product, then the supply curve will shift to the right, rather
than there being a movement along it)

Shifts in supply
If supply shifts to the right (from S1 to S2) this is an increase in supply; more is provided for sale at each price.
If supply moves inwards from S1 to S3, there is a decrease in supply i.e. less will be supplied at each price

Here are the key factors that can cause a shift in the supply curve:
1. Changes in production costs
a. Lower costs of production mean that a business can supply more at each price. For example,
a magazine publisher might see a reduction in the cost of imported paper and inks. These
cost savings can be passed through the supply chain to wholesalers and retailers and may
result in lower prices for consumers.
b. If costs of production increase, for example following a rise in price of raw materials or a firm
having to pay higher wages, businesses cannot supply as much at the same price and this
will cause an inward shift of the supply curve.
c. A fall in the exchange rate causes an increase in prices of imported components and raw
materials and will lead to a decrease in supply. For example, if the pound falls 10% against
the Euro, it becomes more expensive for British car manufacturers to import rubber, glass,
steel and paint from overseas suppliers
2. Changes in technology

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 a. Production technologies can change quickly and in industries where change is rapid, we see
increases in supply and lower prices for consumers.
3. Government taxes and subsidies and regulations
a. Indirect taxes cause an increase in production costs - an inward shift of supply
b. Subsidies bring about a fall in supply costs – an outward shift of supply
c. Regulations increase production costs – an inward shift of supply
4. Changes in climate in agricultural industries
• For commodities such as coffee and wheat, climatic conditions have a big influence on supply.
• Favourable weather will produce a bumper harvest and will increase supply. (An outward shift)
• Unfavourable weather conditions including the effects of drought will lead to a poorer harvest,
lower yields and therefore a decrease in supply (inward shift)
• Because commodities are often used as ingredients in the production of other products, a change
in the supply of one can affect supply and price of another product. Higher coffee prices for
example can lead to an increase in price of coffee-flavoured cakes.

5. Change in prices of a substitute in production

A substitute in production is a product that could have been supplied using the same resources. If
cocoa prices rise for example this may cause some farmers to switch from other crops and invest
money in establishing new cocoa plantations.

6. The number of producers in the market and their objectives

The number of sellers in an industry affects market supply. When new businesses enter a market,
supply increases causing downward pressure on price. If the existing businesses decide to move away
from maximising their profits towards seeking a higher share of the market, total supply available at
each price will increase – the market supply curve will shift outwards.

Examiner tip:

As with demand, it is vital to use language / terminology appropriately and correctly. So, a change in the price
of a product leads to an extension or contraction along the supply curve i.e. a change in the price leads to a
change in the quantity supplied.

A change in any non-price factor leads to a change in supply at each and every price.

Quick question

Think about a good or service that you buy regularly e.g. bus tickets, coffee etc. What non-price factors might
cause a) an increase in supply and b) a decrease in supply?

Why the supply curve is also the MC curve

In a perfectly competitive market structure (covered later in this course companion), no firm has any market
power or influence over the market price. This means that their demand curve is perfectly elastic i.e. horizontal.

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When demand is perfectly elastic, then the marginal revenue from selling an additional unit is exactly the same
as the price. Because economists assume that firms aim to maximise profit, this means they will always operate
at an output level where marginal cost equals marginal revenue (which is the same as the price in this case).
So, whatever the price, the firm will always be operating somewhere on its MC curve. This is a tricky topic to
fully understand at this point in the course, and so it is worth revisiting it after you’ve completed your study of
market structures, and cost/revenue curves in more detail.

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4.1.3.4 Price elasticity of supply

Key specification content:

• Understanding of price elasticity of supply
• Use formula to calculate price elasticity of supply
• Interpret numerical values of price elasticity of supply: perfectly and relatively elastic, and perfectly
and relatively inelastic
• Factors that influence price elasticity of supply
• The distinction between short run and long run in economics and its significance for elasticity of
supply

What is price elasticity of supply?

Price elasticity of supply (PES) measures the relationship between change in quantity supplied and a change
in market price.

If supply is price elastic, producers can increase their output without a rise in cost or a time delay. If supply is
price inelastic, firms find it hard to change their production in a given time period.

The formula for price elasticity of supply is:

% change in quantity supplied
% change in price

Interpreting values of the coefficient of price elasticity of supply

Price elasticity of supply will be a positive number, because the relationship between price and quantity
supplied is positive i.e. the supply curve is upwards sloping.

• When PES > +1, supply is price elastic

• When PES < 1, supply is price inelastic
• When PES = 0, supply is perfectly inelastic (the supply curve is drawn vertically)
• When PES = infinity, supply is perfectly elastic (the supply curve is drawn horizontally)

Perfectly Elastic Supply Perfectly Inelastic Supply

An increase in demand can be Supply is fixed and does not
met without any change in respond to a change the market
Price Price
market price price
S1

P1 S1 P2

D2
P1

D1 D2 D1

Q1 Q2 Quantity Q1 Quantity

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Factors that affect price elasticity of supply

• Spare production capacity: If there is plenty of spare capacity, a business can increase output without
a rise in costs and supply will be elastic in response to a change in demand
• Stocks of finished products and components: If stocks of raw materials and finished products are at a
high level, a firm is able to respond to a change in demand - supply will be elastic. Perishable goods
are often harder/more expensive to store
• Ease and cost of factor substitution/factor mobility: If capital and labour are occupationally mobile,
the elasticity of supply for a product is likely to be higher as resources can be mobilised to supply the
extra output e.g. the reallocation of workers to new tasks. This is more likely to be the case if the skill
level required for the job is relatively low.
• Time period and production speed: Supply is more price elastic the longer the time that a firm is
allowed to adjust its production levels
o The short-run for an economist refers to the period of time in which at least one factor of
production is fixed; in the short-run, PES will be relatively inelastic
o The long-run for an economist refers to the period of time in which all factors of production
are variable; in the long-run, PES will be relatively elastic
• Complexity of the production process: if a production process is particularly complex (e.g. building
an aircraft carrier) then supply will be relatively price inelastic; for a product with a relatively simple
production process (e.g. pencil manufacturing) then supply is more likely to be price elastic.

Elastic supply Inelastic supply

Price Price S2
P2
S1
P2
D2

P1
P1
D2

D1
D1

Q1 Q2 Quantity Q1 Q2 Quantity

Common error alert!

In exams, many students often confuse the factors that affect PED and PES, and this can lead to a significant
loss of marks…be careful!

Quick question

Can you think of a) 5 goods/services that are likely to have price elastic supply and b) 5 goods/services that
are likely to have price inelastic supply? Justify your choices.

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4.1.3.5 The determination of equilibrium market prices

Key specification content:

• Equilibrium price and quantity and how they are determined by the interaction of demand and sipply
• The difference between equilibrium and disequilibrium
• The operation of market forces to eliminate excess demand and excess supply, leading to a change
in price
• The use of supply and demand diagrams to show how shifts in demand and supply curves cause the
equilibrium price and quantity to change in real-world situations
• The model of supply and demand is based on assumptions.

What is meant by market equilibrium and disequilibrium?

Equilibrium means a state of equality or balance between market demand and supply. Disequilibrium is any
other circumstance. Equilibrium price represents a trade-off for buyer and seller – higher prices are good for
the producer (higher revenues and profits) but they make the product more expensive for the buyer. Prices
where demand and supply are out of balance are called points of disequilibrium.

Many exam questions present the student with an event(s) that causes either the demand or supply curve (or
both) to shift. The student is expected to find and analyse the new equilibrium.

Examiner tip:

Frequently, there may be two changes on a demand and supply diagram (one affecting demand and one
affecting supply). Many students fail to gain full marks because they only shift one curve. Always keep an eye
out for possible double shifts!

Example of the equilibrium price and quantity

A football club has a fixed stadium capacity of 8,000 seats and has estimated the level of demand at different
ticket prices as follows:

Price Quantity demanded Quantity supplied

£20 6,000 8,000
£18 7,000 8,000
£16 8,000 8,000
£14 9,000 8,000
£12 10,000 8,000

The equilibrium price in this situation is £16 where quantity demanded and supplied = 8,000 tickets. Supply
and demand are in balance at this number of tickets sold.

Examiner tip:

For exam questions that specifically state that a diagram is required as part of the answer, it is impossible to
gain full marks without the diagram. Those marks will only be awarded if the diagram is ACE, that is, includes
labelling for all Axes, Curves and Equilibrium.

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 Price of Wheat Equilibrium is a state of balance between market demand and supply –
there is no excess demand or supply

Market Supply

Pe is also known as
Pe the “market clearing
price”

Market
Demand

Qe Quantity of wheat

Summary of changes in equilibrium price:

Change in market supply

Demand for and supply of cocoa beans is shown in the table below. The original equilibrium price is $30. If
market supply increases by 900 tonnes at each price, the new equilibrium price will be £25 with 3,500 tonnes
bought & sold.

Price per kg Quantity Quantity supplied Quantity

demanded (1) Supplied (2)
$40 2,000 3,800 4,700
$35 2,500 3,400 4,300
$30 3,000 3,000 3,900
$25 3,500 2,600 3,500
$20 4,000 2,200 3,100
$15 4,500 1,800 2,700

Change in market demand

Demand for and supply of fresh fish in a market is shown in the table below. The original equilibrium price is
£6 per kg. If market demand rises by 140kg at each price, the new equilibrium price will be £8 with 300kg
bought and sold.

Price per kg Quantity demanded (1) Quantity supplied Quantity demanded (2)

£10 100 380 240

£9 130 340 270
£8 160 300 300
£7 190 260 330
£6 220 220 360
£5 250 180 390

Inward shift of market supply

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 Price of Coffee An inward shift of market supply (ceteris paribus) leads to a rise in
equilibrium price and a contraction of market demand

Market
Supply (2)

Market
Supply (1)
P2

Pe

Market Demand (1)

0
Q2 Qe Quantity supplied

Outward shift of market demand

Price of Coffee An outward shift of market demand (ceteris paribus) leads to a rise in
equilibrium price and an expansion of market supply

Market Supply

P2

P1

Market
If price did not rise from P1 after
a shift in demand from D1 to D, Market Demand (2)
there would be excess demand Demand (1)

Q1 Q2 Quantity of Coffee

Shift Equilibrium Price Equilibrium Quantity

Demand increases Higher Higher
Demand decreases Lower Lower
Supply increases Lower Higher
Supply decreases Higher Lower

Examiner tip:
Much of the economics A level is assessed in terms of ‘levels of response’. This means that answers are judged
in terms of their quality. Generally speaking, the quality of analysis is enhanced if there are longer ‘chains of
analysis’ providing deeper explanation as to why certain results have occurred. One way to strengthen these
analytical chains in questions relating to market diagrams is to provide an explanation of how a new
equilibrium is reached – it does not happen immediately or ‘by magic’! The so-called ‘invisible hand’ (a phrase
coined by Adam Smith) must be explained. This is shown below.
Moving from one market equilibrium to another

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Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand
outlined in the previous diagrams are reflective of changes in conditions in the market.

So, an outward shift of demand (depending upon supply conditions) initially leads to a shortage at the existing
market price (i.e. “excess demand”) – at the existing price, quantity demanded is greater than quantity supplied.
The market is now in disequilibrium. There will be waiting lists and queues. This then leads to a short-term
rise in price and a fall in available stocks. This acts as a signal to suppliers. The higher price is then an incentive
for suppliers to raise their output by allocating more resources to this market (termed as an expansion of
supply) causing a movement along the supply curve towards the new equilibrium point. At the same time,
the higher price acts as an incentive for some consumers to ration as price now exceeds their marginal utility.

Disequilibrium – excess demand

• Excess demand is when quantity demanded exceeds available supply and is a state of disequilibrium
in a market.
• Excess demand happens when the current market price is set below the equilibrium price.
• This will result in queuing and an upward pressure on price.
• Higher prices ration demand to those consumers with effective demand
• Higher prices – in theory – stimulate an expansion of supply as producers respond to higher profits

If&the&current&market&price&was&P1,&there&would&be&an&excess%demand%– of&Q1&
– Q4,&this&will&put&upward%pressure%on%price
Price&of&Wheat
Market&
Supply

Pe

P1

Market&
Excess&demand
Demand

Q1 Qe Q4 Quantity&of&Wheat

Disequilibrium – excess supply

• Excess supply is a state of disequilibrium in a market

• When supply is greater than demand and there are unsold goods in the market, there is excess supply
(sometimes known as a ‘glut’)
• Surpluses put downward pressure on the market price.
• As prices fall, there is an extension of demand which cuts the surplus and takes a market towards
equilibrium

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 If&the&current&market&price&was&P2,&there&would&be&an&excess%supply%– of&Q2&
Price&of&Wheat – Q3,&this&will&put&downward%pressure%on%price

Market&
Excess&supply
Supply
P2

Pe

Market&
Demand

Q2 Qe Q3 Quantity&of&Wheat

Quick question:

Take a look at the business section of a newspaper or news website. See if you can find 2 or 3 headlines
relating to price changes. Using your knowledge of demand and supply theory, can you give an explanation
of each price change? Can you draw a demand and supply diagram to illustrate those changes?

Examiner tip:

When drawing demand and supply (market) diagrams, always think about the PED and PES of the good /
service in question – can you reflect that in your diagram?

Furthermore, when there is a shift in the demand curve or supply curve, it is always also worth considering
whether there may be a change in the PED or PES.

Extension – more on the price mechanism

Adam Smith described the invisible hand of the price mechanism in which the hidden hand of the market
operating through the pursuit of self-interest allocated resources in society’s best interest. This remains a view
held by free-market economists who believe in the virtues of an economy with minimal state intervention.

The price mechanism describes how decisions taken by consumers and businesses interact to determine the
allocation of scarce resources between competing uses. The price mechanism plays three important functions:

Signalling function
Prices perform a signalling function – i.e. they adjust to demonstrate where resources are required. Prices rise
and fall to reflect scarcities and surpluses:

• If prices are rising because of high demand from consumers, this is a signal to suppliers to expand
production to meet the higher demand

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 • If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a good
by allowing the market price to fall.
Incentives function
Through choices consumers send information to producers about their changing nature of needs and wants.
Higher prices act as an incentive to raise output because suppliers stand to make a better profit. When demand
is weaker in a recession, supply contracts as producers cut back on output.

One feature of a free-market system is that decision-making is decentralised, i.e. there is no single body
responsible for deciding what to produce and in what quantities.

Rationing function
Prices ration scarce resources when demand outstrips supply. When there is a shortage, price is bid up –
leaving only those with willingness and ability to pay to purchase a product.

More on prices and incentives

1. Incentives matter! For competitive markets to work efficiently all agents (i.e. consumers and
producers) must respond to appropriate price signals in the market.
2. Market failure occurs when signalling and incentive functions fail to operate optimally leading to a
loss of economic and social welfare. For example, a market may fail to consider external costs and
benefits from production and consumption. Consumer preferences for goods and services may be
based on imperfect information on costs and benefits of a decision to buy and consume a product.
This will be covered in more detail later in this Theme 1 course companion.

Examiner tip:

Exam questions can sometimes ask which of the price functions is failing in a particular circumstance e.g. –
incentive, signaling etc., so be sure you know them well!

Assumptions underpinning the model of supply and demand

• Markets are competitive i.e. many buyers and many sellers, none of which have any market
dominance or price-setting power
• Information is perfect i.e. there are no information gaps
• All economic agents are rational, and aim to maximise utility
• Factors of production are mobile

Price volatility in markets

Not all markets experience volatile prices. They tend to be markets with products where the conditions of
supply and demand are stable from year to year and where the price elasticity of demand and the elasticity
of supply are both high. We can see this in the diagram below.

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Products with unstable conditions of supply and demand will experience price fluctuations. For example, for
many products there are seasonal variations in demand that cause prices to rise sharply at peak times and
then fall back during the off-peak periods. Also seasonal demand is strong in the tourism and leisure
industries. Prices for hotel rooms and the prices of package holidays are higher during the school holidays
because hoteliers and travel businesses know that the demand is price inelastic and families will have to pay
higher prices.

Market in action: UK housing market

Speculative buying of High cost of renting a

Mortgage interest rates
properties property (substitute)

High land prices and Low level of new house Incentives such as Help
other building costs building to Buy Scheme

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 £s UK average house price
240000

220000

200000

180000

160000

140000

120000

100000
2005 Jul

2006 Jul

2008 Jul

2009 Jul

2011 Jul

2014 Jul
2007 Jan
2005 Jan

2006 Jan

2008 Jan

2009 Jan

2010 Jan

2012 Jan

2013 Jan

2015 Jan

2016 Jan

2017 Jan
2011 Jan

2014 Jan
2007 Jul

2010 Jul

2012 Jul

2013 Jul

2015 Jul

2016 Jul
The impact of indirect taxes and subsidies on markets
The incentives that consumers and producers have can be changed by government intervention. For example,
there may be changes in relative prices brought about by subsidies and indirect taxation. The government
might also intervene through imposing maximum and minimum prices (which you will meet later in the
syllabus).

Indirect taxes and subsidies

Indirect taxes

Value Added Plastic Bag Fuel Duties Alcohol Duties Tobacco Duties Sugar Tax
Tax Charge
An indirect tax is a tax imposed by the government that increases the supply costs faced by producers. The
amount of the tax is always shown by the vertical distance between the two supply curves. Because of the tax,
less can be supplied at each price level.

An indirect tax will increase the price of a product reducing the quantity demanded i.e. there is a MOVEMENT
ALONG THE DEMAND CURVE (but importantly the demand curve DOES NOT SHIFT!).

The impact of a tax depends upon the price elasticity of demand:

• An indirect tax on suppliers will have no effect on market price if demand is perfectly elastic, although
the equilibrium quantity will fall significantly

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 • An indirect tax on suppliers will be passed onto consumers in full if demand is perfectly elastic i.e.
there will be no change in the equilibrium quantity but a large increase in equilibrium price
Types of indirect tax
A specific tax is a set tax per unit e.g. a £5 tax per unit– this causes a parallel shift in the supply curve

An ad valorem tax is a percentage tax e.g. 20% on the unit price – this causes a pivot shift i.e. non-parallel
shift in the supply curve

Examiner tip

Always read the data and questions in exams carefully to check whether any indirect tax that you need to
analyse is a specific or ad valorem tax.

Analysis of an indirect tax for different PED

• If co-efficient of price elasticity of demand >1 i.e. PED is elastic, most of an indirect tax will be absorbed
by the supplier. Economists say that the “incidence” of the tax is mostly borne by suppliers. This is
shown on the diagram to the left, below.
• If co-efficient of price elasticity of demand <1 i.e. PED in inelastic, most of an indirect tax can be
passed on to the consumer. Economists say that the “incidence” of the tax is mostly borne by
consumers. This situation is shown by the diagram to the right, below.

Price Paid0by0consumer Price S10+0tax

Paid0by0supplier
S10+0tax Tax0Per0Unit
P2
P2 S1 S1

P1
P1
D P3 Paid0by0consumer
P3

Paid0by0supplier

Demand

Q2 Q1 Quantity Q2 Q1 Quantity

Perfectly inelastic and perfectly elastic demand and the burden of a tax

• Perfectly Inelastic Demand: All of the tax is paid by the consumer

• Perfectly Elastic Supply: All of the tax is paid by the consumer

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 To.ensure.that.suppliers.
Price Price receive.the.required.minimum.
Total.tax. Demand
paid.by.the. price.after.an.indirect.tax,.the.
S1.+.tax
consumer market.price.must.rise.by.the.
full.amount.of.the.tax.
P2 S1 P2 S1.+.tax

Tax.Per.Unit
P1

P1 S1

Total.Tax.
Revenue.
(paid.by.the.
consumer) Demand

Quantity Q1 Quantity

Ad-valorem taxes
An ad-valorem tax is an indirect tax based on a percentage of the sales price of a good or service. An increase
in an ad-valorem tax causes an inward shift in the supply curve.

Value&Added&Tax&(the%standard%rate%in%the%UK%
is%20%)%is%an%example%of%an%ad%valorem%tax.
Price S1%+%tax
Insurance&Premium&Tax&is%a%tax%on%general%
insurance%premiums.%There%are%two%rate%
Tax%Per%Unit bands,%the%standard%rate%of%9.5%,%and%a%higher%
rate%of%20%%which%applies%to%travel%insurance,%
P2
S1 appliance%insurance%and%some%car%insurance.

VAT Insurance%Premium%Tax
P1

Demand

Q2 Q1 Quantity

• The effect of an ad valorem tax is to cause a pivotal shift in the supply curve
• This is because the tax is a percentage of the unit cost of supplying the product.
• So, a good that could be supplied for a cost of £50 will now cost £60 when VAT of 20% is applied
• A different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied
• The absolute amount of the tax will go up as the market price increases

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Examiner tips:
A significant number of students shift the demand curve as a result of the imposition of an indirect tax because,
they argue, a tax causes people to buy less. However, they have forgotten that a change in the price causes a
movement along the curve. The supply curve shifts, and the new equilibrium point shows a fall in the quantity
demanded i.e. a movement along rather than a shift. Think about the type of tax imposed if you are drawing
a diagram to illustrate the shift. A unit tax causes a parallel shift and an ad valorem tax causes a pivot shift.

Students sometimes get confused between direct and indirect taxes. This is a topic that they will meet in their
macroeconomics. Direct taxes are taxes that are taken straight from income (e.g. income tax). A rise in direct
tax i.e. an increase in the rate of income tax, is likely to shift the demand curve left for normal goods. Indirect
taxes will always shift the supply curve.

Quick question

Can you draw a demand and supply diagram to illustrate what will happen if the rate of indirect tax on a
good/service is reduced?

Subsidies

Biofuel subsidies for Solar Panel “Feed-In Apprenticeship Aid to businesses

farmers Tariffs” Schemes making losses

Subsidies for wind Food / fuel subsidies Child Care for Subsidies to the rail
farm investment for consumers working families industry

A subsidy is any form of government support—financial or otherwise—offered to producers and (occasionally)

consumers. It does not have to be repaid. A subsidy paid to producers causes an outward shift of the supply
curve leading to a lower equilibrium price and an increase in the quantity traded. This is because it is intended
to lower production costs.

Analysis of government subsidy (to producers)

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 Price

Supply+pre+
subsidy

Subsidy Supply+post+
subsidy
P1

P2
Subsidy+per+unit+is+
shown+ by+the+
vertical+distance
Demand

Q1 Q2 Quantity

Total spending on the subsidy equals the subsidy per unit multiplied by output

Price
Total spending on the subsidy equals the subsidy per unit multiplied by output

Market Supply
Producer pre subsidy
receives
this price

P3 Market Supply
post subsidy
P1

P2

Consumer
pays this Market
price Demand

Q1 Q2 Quantity

In the diagram above, the shaded area shows the total amount spent by the government on the subsidy.
Consumers benefit from lower prices (P2 is lower than P1….and so the total benefit to consumers is the
rectangle bounded by this price difference). Producers also benefit, and get to keep some of the subsidy
themselves (the difference between P1 and P3).

Examiner tip:

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Students typically find it difficult to correctly identify the total amount spent on a subsidy. Make sure that you
can correctly show these areas on diagrams, including those that you have drawn yourself!

Economic and social justifications for a subsidy

Justifications for government subsidies include:

• Helping poorer families with food and childcare costs

• Encourage output and investment in fledgling sectors
• Protect jobs in loss-making industries hit by recession
• Make some key health care treatments more affordable
• Reduce the cost of training & employing workers
• Achieve a more equitable distribution of income
• Reduce some of the external costs of mass transport
• Encourage the arts and other cultural services

Help poorer families e.g. Encourage output and Protect jobs in loss- Make some health care
food and child care investment in fledgling making industries e.g. hit treatments more
costs sectors by a recession affordable

Reduce the cost of Achieve a more Reduce some of the Encourage arts and
training & employing equitable income external costs of other cultural services
workers distribution transport

Analysis of a subsidy – the effect of price elasticity of demand

A subsidy causes an outward shift of supply and – other factors remaining constant – will lead to a lower
market price and an expansion of quantity demanded. Both consumer and producer surplus will increase
following a subsidy.

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 Inelastic*demand Elastic*demand
Subsidy0 has0a0larger0effect0on0the0 Subsidy0 has0a0strong0effect0on0
equilibrium0 price equilibrium0 quantity
Price Price
S1 S1

Subsidy
P1 Subsidy P1
S2
S2 P2
D1

P2

D1

Q1 Q2 Quantity Q1 Q2 Quantity

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4.1.3.6 The interrelationship between markets

Key specification content:

• Changes in particular markets are likely to affect other markets
• This is especially so for goods in joint demand, competitive demand, composite demand, derived
demand and joint supply

Inter-relationships between markets

In the real world, all markets are inter-connected in some shape or form. Supply and demand analysis can
help to explain and inter-relationships between different markets and industries. When showing inter-related
markets, it can be good to make use of a double diagram to help analyse how a change in demand/supply
conditions in one market can influence demand/supply in a related market. Here are two examples:

How an increase in supply in one market may impact upon other markets

Price of coal and demand for renewable energy

Price& Price&of&coal
S1 S2 S1 Coal&is&a&
of&
P1 substitute& source&
solar
of&energy&– if&
P1 solar&power&is&
cheaper,&then&
P2
market&demand&
An&outward&shift& for&coal&used&in&
P2 in&supply&of&solar& power&stations&
power&e.g.&due& might&fall&–
to&improved& causing&an&inward&
technology&or& shift&of&demand
economies&of&
scale&in&solar&
power&output
D1 D2 D1

Quantity&of&solar&power Quantity&of&coal

Examiner tip:

Notice how carefully the above diagram has been labelled, so that it is clear to see which diagram refers to
which market, and the nature of PED and PES in each market.

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How a decrease in demand in one market may impact upon other markets
Demand for new homes and the demand for bricks

Price& Price&of&bricks
S1
of&
P1
new& Falling&demand& Leads&to&an&
homes for&new&homes inward&shift&of&
demand&for&
S1 P2 bricks&– as&bricks&
have&a&derived&
P1 demand

P2

D1

D2 D2 D1

Q2 Q1 Qty&(housing) Q2 Q1 Qty&(bricks)

Quick question:

Think of 2 or 3 different inter-related markets. Now think of possible changes in each of those markets, and
draw relevant demand and supply diagrams to analyse the impact on equilibrium price and quantity in each
market.

Derived demand
Derived demand is the demand for a factor of production used to produce another good or service, for
example:
• Steel: The demand for steel is strongly linked to the market demand for cars and the construction of
new buildings
• Wood: Wood is a product where much of the demand comes from the uses to which it can be put
such as furniture & fencing
• Labour: In factor markets, the demand for labour is derived
• Transport: An increase in the demand for air travel will lead to a rise in the demand for airplane pilots.
• Minerals: Demand for and prices of cobalt and lithium has surged as production of electric vehicles
has grown

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 New homes increases the
Labour is a derived demand
demand for steel

Take up of e-cars increases Internet of Things increases

demand for charging stations demand for cloud servers

Joint demand
Joint demand is when demand for one product is positively related to market demand for a related good or
service. Two complements are said to be in joint demand. The cross (price) elasticity of demand is negative
Examples of joint demand include: fish and chips, iron ore and steel, apps for smartphones

Smartphones and Strawberries and Flights and taxi

Fish and chips
apps cream services

Composite demand
Composite demand is where goods have more than one use. With composite demand, an increase in the
demand for one product (X) leads to a fall in supply of the other (Y).

An example is milk which can be used for cheese, yoghurts, cream, butter and other products including
fertilizer. Another example is land – e.g. farmland can be developed in many different ways, urban land has
different uses. Oil is used in many different industries such as plastics. Straw can be used for animal feed and
also as a bio-fuel

Competitive and joint supply in a market

Goods and services in competitive supply are alternative products that a business could make with its factor
resources of land, labour and capital. An example is the diversion of land used in supplying food to producing
bio-fuels and the impact this has had on global food prices.

Joint supply is when an increase or decrease in the supply of one good leads to the increase or decrease in
supply of a by-product. Examples include beef production leading to a rise in the market supply of beef hides.
Another example is wheat and straw.

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 Cotton and
Beef and hide Lamb and wool Wheat and straw
cotton seed

Competitive demand
Competitive demand refers to goods that compete with each other i.e. substitutes. These are goods that have
a positive cross elasticity of demand.

Extension idea - Secondary markets

Secondary markets occur when buyers and sellers are prepared to use a second market to re-sell items that
have already been purchased. Perhaps the best example is the secondary market in tickets for concerts and
sporting-events.

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4.1.4.1 Production and productivity

Key specification content:

• Production converts inputs, or factors of production, into outputs.

• Productivity is a separate concept and should not be confused.

Production
Production refers to the output of goods and services produced by businesses. To simplify the idea of the
production function, economists create a number of time periods for analysis.

Short run production: The short run is a time period when there is at least one fixed factor input - usually
capital such as machinery and technology. In the short run, the output of a business expands when more
variable factors such as raw materials and extra workers are brought into use

Long run production: In the long run, all of the factors of production can change allowing a business to change
the scale of its operations.

The length of time between the short and the long run will vary from industry to industry. For example, how
long would it take a newly created business delivering sandwiches around a local town to move from the short
to the long run? Let us assume that the business starts off with leased premises to make the sandwiches to
leased vehicles for deliveries and five full-time and part-time staff. In the short run, they can increase
production by using more raw materials and by bringing in extra staff as required. But if demand grows, it
won’t take the business long to perhaps lease another larger building, buy in some more capital equipment
and also lease some extra delivery vans – by the time it has done this, it has already moved into the long run!

Productivity
Productivity is a measure of the efficiency of a factor input. The basic measure of productivity is output per
person employed. Economists usually focus on labour productivity, rather than productivity of other factors
of production.

In general, a better measure of productivity is total factor productivity. This takes into account changes in the
amount of capital in use as well as change in the size of the labour force.
• If the size of an economy’s capital stock grows by 3% and the employed workforce expands by 2%
and output rises by 8%, then total factor productivity has risen by approximately 3%
Why is productivity important?

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Productivity is important in determining living standards, because it helps to quantify how well an economy
uses the resources that it has available, by relating the quantity of inputs to the quantity of output. For many
developed economies in the past few decades, rising productivity has been a key factor in rising income.

Higher productivity can lead to:

• Lower unit costs: these cost savings might be passed onto consumers in the form of lower prices,
which encourages higher demand, rising output and an increase in employment
• Improved competitiveness and trade performance: lower unit costs can lead to reduced international
prices
• Higher profits: if firms can operate more efficiently then this can be a source of higher profits, which
can be reinvested to support long-term growth
• Higher wages: when linked with Marginal Revenue Productivity theory (you will meet this later in the
course), more productive workers can be paid higher wages
• Economic growth: rising productivity can lead to an increase in the trend rate of economic growth
(i.e. higher long-run growth)

Economy in Focus: UK productivity puzzle

Productivity in the UK declined following the Great Recession of 2008/9 and has not (in mid-2019) returned
to its pre-crisis levels, in both the output-per-hour and output-per-worker measures. One possible
explanation is that productivity growth in the run up to the Financial Crisis and subsequent Great Recession
was actually much higher than we would normally expect. However, this is unlikely to provide a full
explanation of the failure of productivity to recover.

One reason for low productivity, according to the OBR, could be low investment following the financial
crisis, as businesses found it more challenging to borrow and suffered lower profits, therefore slashing 2
possible sources of investment finance. At most, though, the OBR reckons weak investment only accounts
for around 1.5 percentage points of the productivity slowdown. Add in concerns over Brexit and the impact
on UK domestic businesses, and there is probably another reason there why investment is lower than we
might expect.

A second reason might be that the UK economy has shifted structurally away from high-productivity sectors
(e.g. finance and construction) to lower-productivity sectors (such as retail). The apparent fall in productivity
could be heightened because of the difficulty in measuring productivity in many service-based jobs. Again,
though, the OBR does not believe this to be a significant reason, contributing just 1 percentage point to the
shortfall in UK productivity.

Other reasons could relate to changes in the UK labour market. Some firms might be ‘hoarding’ labour i.e.
hanging onto workers even though there is not quite enough work for them to do, because it’s cheaper
than paying redundancy or future recruitment when markets pick up. An increasing number of workers are
self-employed, and are generally regarded as less productive – but it is difficult to measure this with any
accuracy.

So-called “zombie” firms may also offer some explanation. These are firms that, ordinarily, would have shut
down, but the availability of very cheap credit due to historically low interest rates means that they can
continue to operate.

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4.1.4.2 Specialisation, division of labour and exchange

Key specification content:

• There are benefits from specialisation and the division of labour

• Specilaisation requires an efficient means of exchange such as money

What is specialisation?
Specialisation is when we concentrate on producing a specific product or task. Specialisation happens at all
levels:
• Specialisation of tasks within extended families in many of the world’s poorest countries
• Within businesses and organisations, for example, specialist buyers employed by supermarkets
• In a country – Bangladesh is a major producer and exporter of textiles; Norway is a leading oil and
gas exporter. And Ghana is one of the biggest global producers of cocoa.
• In a region of a country – for many years the West Midlands has been a centre for motor car assembly,
there has been huge investment in recent years in the Mini plant at Oxford

What is division of labour?

Division of labour is the breaking down of a production process of a good/service into smaller tasks, each of
which is carried out by a different person / factor input. It is a type of specialisation. In the division of labour,
no one person is able to produce an entire product.

Adam Smith and the Division of Labour

Smith famously wrote about the division of labour in his book, The Wealth of Nations, published in 1776.
Smith considered the impact of using division of labour in a pin factory in Glasgow. He claimed that by
separating the production process of pins into 18 different parts, then just 10 workers would be able to
produce 48 000 pins in one day, a significant increase on the number that could be produced if each
worker made a pin in its entirety from start to finish.
Smith realised that the increase in productivity stemmed from workers being able to focus on just one task,
gaining large increases in dexterity, being able to use specialist tools to get the job done, and wasting less
time moving from task to task. He did note, however, that this could cause significant boredom.

What are the possible gains from specialisation?

By concentrating on what people and businesses do best rather than relying on self-sufficiency we may
experience:
• Higher output: Total production of goods and services is raised, and quality can be improved
• Variety: Consumers have access to a greater variety of higher-quality products
• A bigger market: Specialisation and global trade increase the size of the market offering
opportunities for economies of scale to be exploited, leading to lower unit costs and prices

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 Risks of repetitive Reduced job
strain injuries at work satisfaction can hurt
because of repeated productivity and also
tasks causes increased
workplace
absenteeism
Possible disadvantages from specialisation

• Unrewarding, repetitive work that requires little skill can lower motivation and eventually causes lower
productivity.
• Workers may take less pride in work and quality suffers.
• Dissatisfied workers cause absenteeism to increase
• People move to less boring jobs creating a problem of high worker turnover and increased
hiring/training costs
• Increased risk of repetitive strain injuries at work
• Some workers receive little training and may not be able to find alternative jobs when out of work –
they suffer structural unemployment / occupational immobility
• Mass-produced standardized goods may lack variety

Characteristics and functions of money

In any economic system in which there is specialisation, there is a need for money. Prior to specialisation, when
households made products / services in their entirety, they could simply barter (i.e. swapping home-grown
herbs for, say, a loaf of bread), provided that they could find someone to engage in this double coincidence
of wants. However, because specialisation leads to households simply producing part of a good/service, this
leads to them having nothing with which to barter. Therefore, money is needed. For an economist, money is
anything that is generally acceptable in the settlement of a debt. For most economies, this now includes notes,
coins and electronic money. For many people, certainly in the past, it could be anything – shark teeth, shells,
and even rice.

Functions of money

1. A medium of exchange - money is any asset widely acceptable as a medium of exchange. It facilitates
transactions between buyer & seller. Specialisation and the division of labour require a means of
exchanging goods and services.
2. A store of value - an asset that holds its value over time.
3. A unit of account – money is a unit of measure used to value/cost products, assets (e.g. houses),
debts, incomes and spending.
4. A standard of deferred payment - the accepted way, in a given market, to settle a debt.

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 Standard
Medium
Store of Unit of of
of
value account deferred
exchange
payment

Quick questions

Take a look at the chart below.

a) What does the chart show in terms of the trends in cash transactions?
b) What factors do you think explain this trend?
c) Why might it be the poorest people in society that lose out as the use of cash declines?

Forecasted number of cash transactions in the United Kingdom from 2006 to 2026, by denomination (in
billions)
< £1 < £5 < £10

20
Number of transactions in

15

10
billions

0
2006 2016 2026*

Key characteristics of money

Durable and Acceptable when Holds value over

Hard to counterfeit
Portable making transactions time

1. Durability i.e. it needs to last

2. Portable i.e. easy to carry around, convenient, easy to use
3. Divisible i.e. money can be broken down into smaller denominations to facilitate purchases
4. Hard to counterfeit - i.e. it cannot easily be faked or copied by currency fraudsters
5. Accepted i.e. money must be accepted as legal tender – there must be sufficient trust in money
6. Valuable – i.e. it generally holds value over time and is not destroyed by the effects of rapid / hyper-
inflation

Examiner tip

Be careful not to confuse the functions of money with the characteristics of money!

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4.1.4.3 The law of diminishing returns and returns to scale

Key specification content:

• The difference between the short run and the long run
• The difference between average and marginal returns
• The law of diminishing returns
• Returns to scale
• The difference between increasing, constant and decreasing returns to scale
• The implication of these production theories for costs

Short and long run – a reminder

• Short Run Production: At least one of the factor inputs is fixed (usually this is capital but can also be
land). In the short run, businesses are constrained with fixed & variable factors.
• Long Run Production: All factors of production are variable, and the scale of production can also
change allowing a firm to benefit from economies of scale

The concept of diminishing marginal productivity, or diminishing marginal returns, is a short run concept. It is
a production theory concerned with the relationship between inputs and outputs. We use it to explain the
shape of cost curves, but in the short run only.

- Total product = total output (sometimes known as returns), or total units produced
- Marginal product = the additional output produced when an extra worker (or other factor of
production) is employed
- Average product = total output ÷ number of workers. This is also the same as productivity

Common error alert!

Do not confused product or output with productivity!

The Law of Diminishing Returns

In the short run, at least one factor of production is fixed. Let’s assume that this is capital. The only way to
increase output is to employ more workers. Initially, adding an additional worker will cause productivity to rise,
as the workers can use some division of labour and focus on tasks that they are relatively better at. However,
as more workers are added to the fixed amount of capital, the capital becomes increasingly scarce – there
may not be enough to go round, causing workers to get delayed and in each other’s way. This causes
productivity to fall. At the point where marginal product start to fall, we say that “diminishing returns has set
in”.

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 Number of Total output Marginal product Average Product Returns to extra
workers employed labour (n.b. look
1 8 8 8 at what is
happening to
marginal product!)
2 20 12 10 Rising
3 36 16 12 Rising
4 48 12 12 Diminishing
5 55 8 11 Diminishing
6 60 5 10 Diminishing

• When diminishing returns set in then the marginal product of labour starts to fall
• When marginal product of labour declines below existing average product then the average product
of labour will fall – e.g. in this case when the 5th worker is employed

Common error alert!

Do not confuse the law of diminishing returns (which explains short-run cost curves) with the concept of
diminishing marginal utility (which explains the shape of demand curves)

Relationship to cost

When the marginal product of extra labour is falling – assuming that each worker is paid the same wage rate
– then the marginal cost of supplying extra output will increase. Diminishing returns help to explain the
conventional shape of the short-run marginal cost curve (see below).

Returns to scale – a long run production theory

• In the long run, all factors of production are variable

• How the output of a business responds to a change in inputs is called returns to scale

Numerical example of long run returns to scale

Units of Capital Units of Labour Total Output % Change in Inputs % Change in Output Returns to Scale
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing

Consider the table above that shows added capital (K) and labour (L) inputs:

• When we double factor inputs from (150 units of labour + 20 units of capital) to (300 units of labour
+ 40 units of capital) the % change in output is 150% i.e. increasing returns

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 • When the scale of production is changed from (600L + 80K0 to (750L + 100K), the percentage change
in output (13%) is less than the change in inputs (25%) i.e. decreasing returns

• Increasing returns to scale occur when the % change in output > % change in inputs
• When we consider the impact of this on average costs, we call it economies of scale

• Decreasing returns to scale occur when the % change in output < % change in inputs
• When we consider the impact of this on average costs, we call in diseconomies of scale

• Constant returns to scale occur when the % change in output = % change in inputs

The nature of the returns to scale affects the shape of a business’s long run average cost curve – when there
are sizeable increasing returns to scale, we expect to see economies of scale from long run expansion.

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4.1.4.4 Costs of production

Key specification content:

• The difference between fixed and variable costs
• The difference between marginal, average and total costs
• The difference between short and long run costs
• The reasons for the shape of the marginal, average and total cost curves
• How factor prices and productivity affect firms’ costs of production and their choice of factor inputs
• You are expected to be able to calculate different costs from given data and be able to interpret
and draw cost curves.

An important note - Economic costs and opportunity cost

• Economic costs are incurred by a business engaged in producing / supplying an output
• Some of these costs relate to the opportunity cost of production.
• For example, if an entrepreneur invests £200,000 of their own money into a business, that money
could have yielded an alternative return (interest) by being saved in a bank.
• Thus, the next best alternative rate of return on this money is treated as part of the economic cost of
production.
o Accountants typically do not include opportunity cost in their calculations – but economists
do!
• We return to this when we consider the concept of normal profit.

Fixed Costs
• Fixed costs do not vary at all as the level of output changes in the short run
• Fixed cost has to be paid, whatever the level of sales achieved. Fixed costs are incurred even if output
is zero in the short run
• The higher the level of fixed costs in a business, the higher must be the output in order to break-even

Examples of fixed cost

Marketing
Consulting fees Rental costs Research projects
budgets

Fixed salary costs Business insurance

Variable Costs
• Variable costs are costs that relate directly to the production or sale of a product.
• An increase in short run output (Q) will cause total variable cost to rise (TVC).
• Average variable cost (AVC) = total variable cost / output (i.e. TVC divided by Q).
• Variable cost is determined by the marginal cost of extra units as more labour is hired.

Examples of variable cost

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 Commission
Wage costs Component parts Basic raw materials
bonuses

Energy and fuel

Packaging costs
costs

Common error alert!

Exam questions could refer to an increase in rent – this would be an increase in fixed costs! Fixed costs can
change – this does not make them a variable cost.

Students need to be careful when considering the cost of employing workers – this can sometimes be fixed
and sometimes be variable. For example, a salaried employee pay would count as a fixed cost – they get paid
that amount regardless of output. However, if they are eligible for a bonus then that might be related to
output in which case the bonus is a variable cost. Some employees get paid per hour i.e. receive a wage – this
is likely to count as a variable cost.

Calculating average cost

Take a look at the table below – make sure you can work out where all the figures come from.

- Total Cost = Total Fixed Costs + Total Variable Costs

- Marginal Cost = the addition to total costs of producing one more unit
- Average Cost = Total Cost ÷ Output

Output per Total Fixed Total Variable Total Cost Marginal Cost Average Cost
week Costs Costs (£)
(£) (£) (£) (£)
500 300 200 500 0.40 1.00
1000 300 350 650 0.30 0.65
1500 300 450 750 0.20 0.50
2000 300 500 800 0.10 0.40
2500 300 700 1000 0.40 0.40
3000 300 1000 1300 0.60 0.43
3500 300 1600 1900 1.20 0.54
4000 300 2600 2900 2.00 0.73

Short run cost curves

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Marginal Cost and Average Cost
The diagram below shows the relationship between the marginal and the average cost curve:

Cost AC will rise MC

when AC
MC > AC

AC will fall
when
MC < AC

Average cost is at a
minimum when it is
intersected by the
MC curve

Output

Examiner tip:

You need to know that AC = MC at the lowest point of the AC curve. Practice drawing these diagrams so that
you can use them accurately and with confidence in exam questions!

Fixed and variable costs on diagrams

Cost MC
AFC will fall as AC
the level of
output
expands
AVC
AFC

MC also cuts AVC

curve at min of AVC

Explaining the diagram above:

• Average variable cost (AVC) is variable cost per unit of output.
• The shape of AVC is determined by the shape of marginal cost – rising MC is due to diminishing
returns
• Average fixed costs fall continuously as output increases because total fixed costs are being spread
over a higher level of production
o AFC is the difference between AC and AVC
o The diagram that follows shows how you can draw total fixed costs and average fixed costs

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Examiner tip:

You must be able to explain the shapes of the curves that you draw, and not simply be able to ‘repeat’ the
diagram.

Examiner tip:

Sometimes you may be asked to identify different types of costs from a table of data. Remember that you can
easily spot the Total Fixed Costs, as this will be the Total Cost when output is zero.

Causes of shifts in short run costs

Earlier, you studied the factors that causes shifts in the supply curve. The MC curve is the same as the supply
curve – so factors that would shift supply will also shift MC.

Factors causing shifts in Supply Costs

1. Changes in the unit costs of production

a. Lower unit costs mean that a business can supply more at each price – for example higher
labour productivity
b. Higher unit costs cause an inward shift of supply e.g. a rise in wage rates or an increase in
energy prices / other raw material prices
2. A fall (depreciation) in the exchange rate causes higher prices of imported components and raw
materials
3. Advances in production technologies – outward shift of supply
4. The entry of new producers into the market – outward shift
5. Favourable weather conditions e.g. for agricultural products – increased supply
6. Taxes, subsidies and government regulations
a. Indirect taxes cause an inward shift of supply
b. Subsidies cause an outward shift of supply

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 c. Regulations increase costs – causing an inward shift of supply

A rise in fixed costs

• An increase in fixed costs causes an upward shift in average total cost but does not cause the marginal
cost curve to change!
• A change in fixed costs will only shift the AC curve and not the MC curve; a change in variable costs
will shift both

Cost MC AC2

AC1

AVC

A change in fixed costs has

no effect on marginal costs.
Marginal costs relate only to
variable costs!

Output

An increase in variable costs

MC2
Cost MC1
AC2

AC1

A rise in variable costs of

production leads to an upward
shift both in marginal and
average total cost

Output

Examiner Tip

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 Questions on changes in cost appear quite frequently in all sections of the exam paper – you may need to
give a written explanation and/or draw a diagram. But many candidates do not remember that changes in
fixed costs have a different effect on cost curves compared to variable costs – make sure that you
thoroughly learn the difference, and make your answer stand out from the crowd!

Also remember that information on changing costs may be given in a qualitative way i.e. in words, in the
case study. It will be your task to work out whether the costs described are fixed or variable – do not expect
the examiner to explicitly point it out!

Ways in which changes in government economic policy can influence the costs of businesses
1. Changes in value added tax (VAT) and other indirect taxes on producers such as the Sugar Levy
2. Environmental taxes (including a possible carbon tax) and introducing a minimum price for each
tonne of carbon emitted within the EU carbon trading scheme
3. Changes in labour market interventions such as the National Minimum Wage
4. Government subsidies targeting producers such as an employment subsidy or guaranteed minimum
payment

Finding an optimal mix between labour and capital

• In the long run businesses will be looking for an output that combines labour and capital in a way
that maximises productivity and reduces unit costs towards their lowest level.
• This may involve a process of capital-labour substitution where capital machinery and new technology
replaces some of the labour input.

Long Run Average Cost (LRAC)

• In the long run, all factors of production (and therefore costs) are assumed to be variable and this
means that the scale of production can change
• Economies of scale are the unit cost advantages from expanding the scale of production in the long
run. The effect is to reduce average costs over a range of output

Factor prices and choice of factor inputs

The 4 main factors of production are effectively substitutes for each; this is especially true of capital and labour.
As labour costs rise (for example, due to rising real wage rates, rising employer National Insurance
contributions, rising pension costs etc.), businesses may seek to substitute capital for labour. Similarly, if capital
becomes expensive (if interest rates on loans used to buy new capital rise, for example) then employers may
substitute labour for capital. The precise mix of capital and labour used in a business is dependent on the
productivity of those factor inputs and their factor cost.

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4.1.4.5 Economies and diseconomies of scale

Key specification content:

• Internal and external economies of scale, including examples
• Reasons for economies of scale
• The relationship between returns to scale and economies and diseconomies of scale
• The relationship between economies of scale, diseconomies of scale and the LRATC curve
• Minimum efficient scale and its significance for industry structure and barriers to entry.

Economies of scale are the unit cost advantages from expanding the scale of production in the long run. The
effect is to reduce average costs over a range of output. In other words, economies of scale exist when long
run average costs fall as output rises. Internal economies of scale are specific to a business whereas external
economies of scale are achieved when a whole industry grows. These lower average costs represent an
improvement in productive efficiency and can give a business a competitive advantage in a market.
• They can also lead to lower prices (if the firm chooses to pass on the cost savings) and higher profits
• As long as the long run average total cost curve (LRAC) is declining, then internal economies of scale
are being exploited by a business.

Average
Cost
(Unit Economies of
Cost) scale cause
AC to fall
Lowest point on LRAC LRAC
is output of
productive efficiency

Rising LRAC – means

diseconomies of scale

Q1 Q2 Q3 Output

Diseconomies of scale are mentioned in the diagram above, but you can find more detail on the theory
underpinning this concept a little later in this chapter.

Common error alert!

The shape of the SRAC and the LRAC curves are the same, and it is not surprising therefore that many students
get confused that there are different explanations of their shapes. SRAC is explained by the Law of Diminishing
(Marginal) Returns. LRAC is explained by economies/diseconomies of scale. In many cases, this links closely
to returns to scale but remember this is a production theory.

You must look very carefully at exam questions and identify if there is any reference to the SR or LR, and then
consider the theory that might apply.

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 Technical economies i.e. Purchasing economies Managerial economies – Financial economies e.g.
containerization in e.g. bulk-buy purchases e.g. employing lower interest rates on
shipping and freight – this is an example of specialized staff to raise loans for larger firms
monopsony power efficiency

Risk-bearing economies Network economies –

arise from product networks of suppliers /
diversification and customers – with a low
market diversification marginal cost of adding users

Examiner tip:

Exam questions relating to economies of scale occur frequently, especially in data response questions when
students could be asked to analyse or discuss possible reasons for economies of scale in a given industry /
market. The best answers drill down into the detail and give specific types of economies of scale, such as
technical or purchasing (see below), that are fully applied to the industry in question. For example, suppose
the industry was chocolate manufacturing, then producers will likely buy cocoa beans and milk in bulk, and
may benefit from technical economies such as high-volume chocolate wrapping machines.

Technical economies of scale:

There are several different causes of technical economies of scale:

• Expensive (indivisible) capital inputs: Large-scale businesses can afford to invest in specialist capital
machinery. For example, a supermarket might invest in database technology that improves stock
control and reduces transportation and distribution costs. A smaller independent store may not be
able to justify this initial cost.

• Specialisation of the workforce: Larger firms can split the production processes into separate tasks to
boost productivity. Examples include the use of division of labour in the mass production of motor
vehicles and in manufacturing electronic products.

• Law of increased dimensions (known as the container principle) This is linked to the cubic law where
doubling the height and width of a tanker or building leads to a more than proportionate increase in
cubic capacity
o The application of this law opens up the possibility of scale economies in distribution and
freight industries and also in travel and leisure sectors with the emergence of super-cruisers
o The law of increased dimensions is important in energy sectors, office rental and
warehousing. It is also significant in long haul airlines and cruise-ships

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 • Learning by doing: The average costs of production decline in real terms as a result of production
experience as businesses cut waste and find the most productive means of producing output on a
bigger scale. Evidence across a wide range of industries into so-called “progress ratios”, or “experience
curves”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each
doubling of cumulative output.

Marketing Economies - Monopsony Power:

• In larger firms, fixed costs such as advertising campaigns have a smaller effect on the cost per unit

• A large firm can purchase factor inputs in bulk at lower prices if it has monopsony power – we can
call these purchasing economies. Large food retailers have monopsony power when purchasing their
supplies from farmers and wine growers and in completing supply contracts from food processing
businesses.

• For example, Amazon has huge buying power in the publishing industry. It has a 30 per cent share
of the physical book market in the US and more than 60 per cent of eBooks, and uses this power to
reduce the prices it pays publishers for the books sold on the Amazon web site

Managerial economies of scale:

• This is division of labour where firms employ specialists to supervise production systems

• Better management and increased investment in human resources and the use of specialist
equipment, such as networked computers can improve communication, raise productivity and
thereby reduce unit costs.

Financial economies of scale:

• The financial markets usually rate larger firms to be more ‘credit worthy’ and have access to credit
with favourable rates of borrowing – they may borrow much more overall than a small firm and pay
a lower rate of interest (although the bank still benefits because of the large amount borrowed)

• Smaller firms often pay higher interest rate on overdrafts and loans. Businesses quoted on the stock
market can normally raise new financial capital more cheaply through the sale of equities to the capital
market.

Network economies of scale:

• Some networks and services have huge potential for economies of scale. That is, as they are more
widely used (or adopted), they become more valuable to the business that provides them.

• In most cases, the marginal cost of adding one more user or customer to a network is close to zero,
but the resulting financial benefits may be huge because each new user to the network can trade with
the existing members or parts of the network.

• Given the high fixed costs of establishing a network, the more users there are the lower are the fixed
costs per unit. As a network expands, not only are there gains from extra revenues, but the long run
cost per user diminishes – this is an internal economy of scale and a key factor behind the profitability
of network businesses such as Netflix, Google, Amazon and Facebook.

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External Economies of Scale (EEoS)
External economies of scale involve changes outside of the business i.e. they result from the expansion of the
entire industry of which the business is a member. They lower unit costs for many / all firms inside the market
(even small firms!). The entire LRAC curve will shift downwards. The graphic below shows some examples of
external economies of scale.

University Research Transport Networks Relocation of Influx of human

Departments helping lower logistics costs Suppliers to the capital – highly
to fund research centre of production skilled workers

Diseconomies of Scale

Higher Regulatory Costs Office Politics / Industrial Risk aversion among Waste / Inefficiency in
for bigger Businesses Relations salaried staff large organisations

What are diseconomies of scale?

Diseconomies of scale are increases in the unit (average) cost of supply in the long run due to decreasing
returns to scale. Diseconomies of scale mean that

• A business has moved beyond their optimum size

• Businesses are suffering from productive inefficiency because of organisational slack
• Breakdowns in communication may lead to the departure of highly skilled workers from a business
• Worker morale can suffer which then reduces productivity and increases unit costs. Higher unit costs
will reduce total profits. Businesses may then have to raise prices to cover increased costs
• Lost competitiveness could lead to declining market share and a fall in the share price if the business
is listed on the stock market

Causes of diseconomies of scale

Diseconomies may be due to:
1. Control and communication problems – i.e. problems in monitoring productivity and work quality,
risking increasing wastage of resources which adds to cost but not to total output
2. Co-operation problems - workers in large firms may develop a sense of alienation and loss of morale
3. Negative effects of internal corporate politics, information over-load for employees, unrealistic
expectations among managers and cultural clashes between senior people with inflated egos

Consequences of diseconomies of scale

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 • Diseconomies lead to a rise in a firm’s long run average cost of production.
• They result from a business expanding beyond an optimum size and losing productive efficiency
• Higher long run average costs will reduce the profitability of a business if their prices remain the same

Analysis diagram to show the impact on profits of diseconomies of scale

Price
and Producing an output beyond the minimum efficient scale e.g.
Cost at Q2 leads to lower total profits. Diseconomies of scale
cause unit costs to be higher than at output Q1.

P1

LRAC
P2

C2

C1 AR

Q1 Q2 Output

Minimum Efficient Scale (MES)

What is the minimum efficient scale?

• It is the scale of production where all of the internal economies of scale have been fully exploited
• MES corresponds to the lowest level of output at which the lowest point on a firm’s long run average
cost curve (LRAC) is reached
• MES is likely to be low relative to the size of market demand in a very competitive industry – this
means there is room for many businesses to compete for example, hotels competing for custom in a
city centre
• MES is likely to be high in a natural monopoly – which means that the industry will be highly
concentrated
• If LRAC remains the same as output increases, then a firm is experiencing constant returns to scale
• Typically, if the MES is high, the market is likely to highly concentrated – this is because a high MES is
effectively a high barrier to entry, preventing new firms from easily joining a particular industry /
market

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 Cost
per unit The minimum efficient scale is the scale of output where internal
economies of scale have been fully exploited

LRAC

Economies of Constant Diseconomies

scale returns to scale of scale
(increasing
returns)

Output

Three causes of a business having a high minimum efficient scale

1. MES will tend to be high when the fixed costs of setting up production are large e.g. in
pharmaceuticals where it can cost of hundreds of millions of £s to bring a new drug to market because
of research and testing costs.
2. MES will tend to be high when the marginal cost of supplying to extra customers is low relative to
fixed costs. For example, many digital businesses grow rapidly because the marginal cost of adding
one extra user to the network is very low. They can benefit from network economies of scale.
3. With a natural monopoly, long run average cost may continue to fall across the entire range of output
which means that the minimum efficient scale is a very high percentage of total market demand.
Thus, there might be room for only one firm to fully exploit economies of scale.

Examples of markets with a high minimum efficient scale:

• Water, gas and electricity supply
• Underground transport systems
• Social networks and search engines

Examples of markets with a low minimum efficient scale:

• Cafes and coffee shops in a large city
• Hotels
• Dry cleaners

Common error alert!

Internal economies of scale occur when the business itself expands, causing a movement along its LRAC
curve as average costs fall. They are associated with large businesses.

External economies of scale occur when the industry expands, causing the LRAC curve for every firm in the
industry to shift downwards. Businesses can benefit if they are large or small.

L-shaped LRAC curves

Some firms need to produce very high levels of output in order to benefit from any economies of scale and
experience falling long-run average costs; this is typically the case in firms that have large sunk costs, and are
involved in providing a ‘network’ of some kind e.g. National Grid, Network Rail etc. These firms are known as
natural monopolies – it only makes sense, from an efficiency point of view, for there to be one firm in the

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market. For these firms, their long-run average costs are always falling and they rarely reach the minimum
efficient scale of output.

The LRAC curve for such firms could look like this:

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4.1.4.6 Marginal, average and total revenue

Key specification content:

• The difference between marginal, average and total revenue
• Why the average revenue curve is the firm’s demand curve
• The relationship between average and marginal revenue
• The relationship between marginal revenue and total revenue
• You should be able to calculate marginal, average and total revenue from given data and draw
and interpret revenue curves.

Key Revenue Concepts

• Revenue
o Revenue is the income generated from the sale of goods and services in a market
• Average Revenue
o Average Revenue (AR) = price per unit = total revenue / output (also known as the demand
curve)
• Marginal Revenue
o Marginal Revenue (MR) = the change in revenue from selling one extra unit of output
• Total Revenue
o Total Revenue (TR) = Price per unit x Quantity or AR x Q

Numerical Example 1
The example below is a relatively simple example of how to calculate TR and MR. Make sure that you can
calculate the same numbers as shown below!

Price per unit Demand (units) Total Revenue Marginal Revenue

(= Average Revenue) (AR x Quantity) (Change in TR as 1 extra
unit is added)
£20 5 £100
£18 6 £108 £8
£16 7 £112 £4
£14 8 £112 £0
£12 9 £108 -£4
£10 10 £100 -£8
£8 11 £88 -£12

Average revenue and the demand curve

Note on the table above that for each number of units demanded, average revenue equals price. This
demonstrates that the average revenue curve is the firm’s demand curve.

Numerical Example 2
This is a slightly more challenging example, because as the price (or AR) falls, the quantity demanded does
not just rise by 1 unit, but instead rises by 50 units at a time. This means you will need to be extra careful when
calculating MR! In this case, you cannot simply calculate the difference in TR, because this would give you the
addition to TR as a result of quantity demanded increasing by 50 units. So, you need to divide the change in
TR by the change in quantity demanded.

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 Price per unit Demand (units) Total Revenue Marginal Revenue
(= Average Revenue) (AR x Quantity)
£20 200 £4000
£18 250 £4500 £10
£16 300 £4800 £6
£14 350 £4900 £2
£12 400 £4800 -£2
£10 450 £4500 -£6
£8 500 £4000 -£10

Maximising revenue
• Maximum total revenue occurs where marginal revenue is zero: i.e. no more added revenue can be
achieved from producing and then selling an extra unit of output.
o You can see this point in Numerical Example 1 (above), where revenue is maximised between
units 7 and 8
• The point where MR=zero is directly underneath the mid-point of a linear demand curve.
• When marginal revenue is zero, the coefficient of price elasticity of demand = 1
o That is, PED is unitary when TR is maximised
• When marginal revenue becomes negative, if prices were cut further, then total revenue would fall
o When MR is positive, PED is relatively elastic
§ A fall in price is proportionately smaller than the increase in quantity demanded
o When MR is negative, PED is relatively inelastic
§ A fall in price is proportionately larger than the increase in quantity demanded

Diagram to show average and marginal revenue and revenue maximisation

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Price takers and price makers

Price takers:
• Price takers operate in highly (perfectly) competitive markets
• They have no pricing power and have to accept the prevailing market price and do as well as they
can
o This means that they have a perfectly elastic demand curve
o AR will be identical to MR, because every unit will be sold at exactly the same price
• Price takers have a low percentage market share
• Their TR curve will simply be an upwards sloping line, starting from the origin

Price makers:
• Price makers have the ability / power to set their own prices for the goods and services they sell
• This happens in all imperfectly competitive markets
• The demand curve (AR curve) is downward sloping
• Marginal revenue (MR) will lie below AR

Examiner tip:

Look out for the phrase ‘price taker’ or ‘price maker’ in exam questions, as it gives you clues as to the shape
of the AR (i.e. demand) and MR curves.

Diagrams to illustrate AR, MR and TR for Price Making Firms and Price Taking Firms

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Price elasticity of demand and total revenue – in more detail
• Price elasticity of demand along a straight-line demand curve will vary
• At high prices, a fall in price will have an elastic price response – i.e. cutting prices causes total revenue
to rise
• Demand is price inelastic (Ped < 1) towards the bottom of the demand curve – i.e. a fall in price causes
total revenue to drop

Price A fall in market price from P1 to

P2 causes total spending to rise,
P1 therefore PED >1

P2 Fall in price
from P3 to P4
causes
spending to
fall as PED <1

P3
P4

Q1 Q2 Q3 Q4 Qty

Example of price changes and consequences for total revenue

A business is selling carpet at a unit price of £8 per square metre. Currently it sells 400 square metres per day.
After cutting the price to £7 per square metre, it finds that daily sales of carpet expand to 500.

Estimated price elasticity of demand = % change in quantity demanded / % change in price

• % change in quantity demanded = 25%
• % change in price = 12.5%
• The price elasticity of demand for this price change = 25/12.5 = 2 (i.e. price elastic)
Total revenue when price = £8 = (£8 x 400) = £3,200
Total revenue when price = £7 = (£7 x 500) = £3,500

When demand is price inelastic, i.e. coefficient of price elasticity < 1, a fall in price will lead to a drop in total
revenue. A summary of price elasticity of demand and its relationship to revenue is shown in the table:

Price per unit Demand (units) Total Revenue Co-efficient of price elasticity of demand (PED)
(Price x Quantity)
£20 200 £4000 2.5
£18 250 £4500 (elastic demand, revenue rises)
£16 300 £4800 1.3
£14 350 £4900 (elastic demand, revenue rises)
£12 400 £4800 0.75
£10 450 £4500 (inelastic demand, revenue falls)
£8 500 £4000

Examiner tip

Earlier, you covered the factors that will increase or decrease demand (i.e. shift demand curves right or
left). Because the AR curve is the same as the demand curve, exactly the same factors will affect AR as
demand! It is worth you reviewing this topic at this point.

One extra thing to remember, if you move the AR curve, the MR curve that accompanies it must also shift!

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4.1.4.7 Profit

Key specification content:

• Profit is the difference between total revenue and total cost
• The difference between normal and abnormal (supernormal) profit
• The role of profit in a market economy

Profit = total revenue minus total cost.

Different types of profit

Normal Profit
• Normal profit is the minimum profit needed to keep factor inputs in their current use in the long run.
• Normal profits reflect the opportunity cost of using funds to finance a business. If you put £200,000
of savings into a new business, those funds could have earned a low-risk rate of return by being saved
in a bank account. You might use the rate of interest on that £200,000 as the minimum rate of return
that you need
• Because we treat normal profit as an opportunity cost of investing financial capital, then we include
normal profit in the average total cost curve
o Remember – accountants do not do this!
• Thus, if price at least covers AC then a business is making normal profits in a market

Supernormal profit
• Profit achieved in excess of normal profit.
• Profit when AR > AC
• When firms are making supernormal profits, there is an incentive for other producers to enter a
market
• Note that you may sometimes see supernormal profits referred to as abnormal profits – this is the
same thing!

Subnormal profit
• This is profit less than normal (i.e. price per unit < average cost)
• Also known as an economic loss
• If we looked at a business’s accounts, it may appear that they are making an “accounting profit”
(remember that accountants do not include opportunity cost in the business’s costs of production)

Diagrammatic analysis of different profit points

All of the diagrams below represent a price-making firm operating at the point where MR = MC i.e. profit
maximising. However, the outcome in terms of profit in each case is different.

Importance of Profit

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Profit is an important objective of most but not all firms
1. Finance for capital investment and research: Retained profits are a key source of finance for businesses
undertaking investment + funds for acquisitions
2. Market entry: Rising supernormal profits send signals to other producers within a market
3. Demand for and flow of factor resources: Resources flow where the risk-adjusted rate of profit is
highest
4. Signals about health of the economy: Rising profits might reflect improvements in supply-side
performance. They are also the result of higher levels of aggregate demand for example during an
economic recovery

Calculating Economic Profit

The data below is for an owner-managed firm for a given year
• Total revenue £320,000
• Raw material costs £30,000
• Wages and salaries £85,000
• Interest paid on bank loan £30,000
• Salary the owner could have earned elsewhere £32,000
• Interest forgone on capital invested in the business £20,000

In a simple accounting sense, the business has total revenue of £320,000 and total costs of £145,000 giving an
accounting profit of £175,000.

• But profit according to an economist should take into account the opportunity cost of the capital
invested and the income that the owner could have earned elsewhere.
• Taking these two items into account we find that the economic profit is lower equal to £123,000.

Numerical Example of Calculating Profit

Price Per Demand Total Marginal Total Cost Marginal Total

Unit Output Revenue Revenue (TC) Cost Profit
AR (Units) (TR) (MR) (£) (MC) (£)
(£) (£) (£) (£)
50 33 1650 2000 -350
48 39 1872 37 2120 20 -248
46 45 2070 33 2222 17 -152
44 51 2244 29 2312 15 -68
42 57 2394 25 2384 12 10
40 63 2520 21 2444 10 76
38 69 2622 17 2480 6 142
36 75 2700 13 2534 9 166
34 81 2754 9 2612 13 142

• The firm moves into profit at an output level of 57 units.

• Thereafter profit is increasing because the marginal revenue from selling units is greater than the
marginal cost of producing them.
• But once marginal cost is greater than marginal revenue, total profits are falling

You can see this represented diagrammatically below:

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 Price,) MC
Cost Profit)
maximised)
here

Marginal)
profit)is)
negative
Marginal)
profit)is)
positive

MR

Q1 Output

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4.1.4.8 Technological change

Key specification content:

• Innovation and invention
• Technological change and its effect on methods of production, productivity, efficiency and firms’
costs of production
• The link between creative destruction, technological change, the development of new markets and
the destruction of existing markets
• How technological change influences the structure of markets.

Innovation in markets
Innovation is putting a new idea or approach into action. Innovation is 'the commercially successful exploitation
of ideas.'

Product innovation
• Small-scale and frequent subtle changes to the characteristics and performance of a good or a service
Process innovation
• Changes to the way in which production takes place or is organised
• Changes in business models and pricing strategies

Innovation has demand and supply-side effects in markets and the economy as a whole

Austrian economist Joseph Schumpeter coined the term creative destruction which refers to the upheaval of
the established order in the pursuit of innovation. Smaller disruptive businesses often challenge existing firms
with market power.

How technology changes business models (examples)

• Print magazine and newspaper readership
o Falling as more consumer prefer to browse online (increasingly via social media)
o Impact is lower print circulation and subscription revenues + a knock-on effect on advertising
o The Independent has stopped their print edition – now online only – other newspapers will
probably follow suit
• Data storage devices
o Demand for memory sticks and other storage devices surged in the last 5-10 years as
consumers and businesses created so much more data
o Now most businesses (and increasingly consumers) want to store their data on the Cloud
rather than a single device

Schumpeter’s Creative Destruction (examples)

• Music and book retailing (Amazon)
• Grocery retailing (Ocado, Amazon, Tesco)
• Holidays (Expedia, Trip Advisor)
• Gambling (Bet365, FoxyBingo)
• File storage and sharing (Dropbox)
• Music streaming (Spotify & iMusic)
• Sharing economy (Uber, Airbnb)
• Media consumption (Netflix, YouTube)
• Media sharing (Snapchat, Facebook)
• News publishing (Twitter, Huffington Post, Buzz Feed)

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E-Commerce and Market Structures
The rise of e-commerce is causing changes in many industries/sectors. 15 years ago – these businesses did
not exist:
• Facebook
• Twitter
• YouTube
• Uber
• Airbnb
• Snapchat
• Instagram
• Fitbit
• Spotify
• Dropbox
Is e-commerce leading to increased competition and enhanced economic efficiency and welfare?
Or are we seeing the rapid emergence of new digital monopolies who will be super-profitable?

Microeconomic Impact of E-Commerce

The development of e-commerce has affected almost all of these factors in most industries and markets.
1. Size (revenues, quantity)
2. Size distribution of firms
3. Distribution channels
4. Profitability of businesses
5. Number of and closeness of substitutes
6. Nature of costs in the short and the long run
7. Extent of vertical integration
8. Barriers to entry & exit
9. Openness of markets and businesses to intense international competition

Pure-Play E-Commerce Retailers

A pure play is a business that originated and does business purely through the Internet; they have no physical
store (“bricks and mortar”) where customers can shop.

Pure Plays and Market Contestability

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 Pure-Play E-Commerce Firm Key Traditional Rivals
Uber City taxi firms e.g. Black Cabs
ASOS Topshop, H&M and Next
Airbnb Major hotel groups (e.g. Marriott, IHG)
Ocado Tesco, Asda, Sainsbury’s, Waitrose
Bet365 William Hill & Ladbrokes
Amazon All physical retailers!

Has E-Commerce cut barriers to entry?

Yes
• Widespread availability of smartphones and the associated app “eco-system” has created new ways
of delivering existing products & services
• Global e-commerce platforms such as Amazon, eBay, Google, Alibaba etc. have made it much easier
& cheaper for small businesses to access their target customer base
• E-commerce has made it much easier to expand into international markets
No
• Most successful new market entrants have to invest heavily in e-commerce systems
• Existing players have the resources to protect their market position – e.g. Argos, Topshop, John Lewis
& HMV are all investing heavily in Omnichannel retailing
• The best-performing e-commerce businesses are increasingly the biggest too – network economies
of scale now more important
• Amazon’s market dominance has become a competition issue

Platform businesses and the sharing economy

Many of the “sharing economy” e-commerce businesses own no substantial assets. This reduces the capital
they need to operate. Does that give them competitive cost advantage over traditional established businesses?

E-Commerce and Network Economies

Network economies are best explained by saying that the extra cost of adding one more user to the network
is close to zero, but the resulting benefits may be huge because each new user to the network can then
interact, trade with all of the existing members or parts of the network. The expansion of e-commerce is a
great example of network economies of scale – it doesn't cost Amazon much (if anything) to add another
100,000 customers or another 100,000 products to its systems, but the revenue and profit effect can be
significant.

How Established Firms Fight Back!

Competitive Examples
Advantage?
Brand loyalty Brand loyalty is built over many years, particularly in service
businesses (e.g. John Lewis, Nike, Dominos, Hyatt Hotels)
Physical store Major high street retailers (e.g. Argos, Waitrose & John Lewis)
network have extensive store networks that can be used to support non-
price competition such as “click & collect” and expert face-to-
face advice
The option of Traditional model businesses have the option of adapting their
Omnichannel models to also offer e-commerce as part of an integrated

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 approach. Successful Omnichannel retailing is a great example
of this – Apple is doing this successfully

4.1.5.1 Market structures

Key specification content:

• The spectrum of competition ranging from perfect competition to pure monopoly
• The number of firms, product differentiation and easy of entry are used to distinguish between
different market structures.

Key Features of Market Structure

The most important features of market structure are:
1. Number of firms (including the scale and extent of foreign competition)
2. Market share of the largest firms
3. Nature of production costs (including the potential for firms to exploit economies of scale in the long
run)
4. Degree to which the industry is vertically integrated i.e. a business has strong control over the supply-
chain
5. Extent of product differentiation (which then affects the coefficient of cross-price elasticity of demand)
6. Structure of buyers in the industry (including the possibility of monopsony (buying) power)
7. Turnover of customers – i.e. how many customers are prepared to switch their supplier to a rival firm?
8. The size and strength of barriers to entry in general

Market Structure – Importance of the Nature of Cost

Costs of supply will vary between industries and they can have a significant effect on the degree to which a
market is highly competitive or – in contrast – closer to being a monopoly / duopoly or an oligopoly with a
handful of dominant businesses. These cost factors include:

• Entry costs into a market

o Capital costs will vary from industry to industry
o E.g. a natural monopoly such as energy and power networks
• Sunk costs / exit costs
o These are costs that are not recoverable if a business leaves
o E.g. advertising and marketing
o Depreciation of capital equipment
o High sunk costs makes a market less contestable
• Natural cost advantages
o Location advantages e.g. close to ports, access to cheaper labour
o Ownership of important raw materials
• Control of the supply chain in a market through vertical integration

Market Structure – Product Differentiation

One way of comparing and contrasting different market structures is to think about the nature of the products
available for consumers to buy.
• Homogeneous goods
o Essentially the same physical characteristics
o Associated with perfect competition
o Different grades are possible e.g. steel, cement, coal, fresh fruit

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 • Non-homogeneous goods
o Products differentiated from their competitors
o Branding, packaging and marketing are key here
o Strong product differentiation and brand loyalty allows firms to charge higher premium
prices
o Demand become less price elastic / less price sensitive
o Reduction in the cross-price elasticity of demand (products are weaker substitutes)
o Higher profit margins for a given unit cost when demand has a low price elasticity

Market Conduct
Market conduct refers to how businesses actually behave in the industries in which they operate. How does
market structure affect the pricing, output and other decisions of businesses within the market? Examples of
conduct issues include the following:
• Are there dominant firms?
• Is there evidence of anti-competitive behaviour?
• How much control do businesses have over the supply chain?
• How important is non-price competition in the market?
• Is there interdependence between firms?
• Do businesses behave strategically to retain profits by deterring the entry of new competitors in the
long run?
Note: Be aware also that the market structure will then affect the behaviour of firms especially in contestable
industries.

Market Performance Affects Market Structure

1. Performance can affect market structure over time
o Top performing firms will gain market share at expense of rivals
o This gives them more market power
o There is a fine line between market dominance and economic efficiency
2. Market conduct affects structure
o E.g. decisions about research and development and marketing
o Strategic behaviour of firms especially in oligopoly makes it difficult to rely on the structure
conduct performance model

Overview of Key Market Structures

Number of Nature of the Are there How strong What is the What is the What is the
firms likely to product significant is the potential to likely likely
exist in the available to barriers to pricing earn outcome for outcome
industry consumers entry for power of supernormal allocative for
new firms? individual profits in the efficiency? productive
firms in the long run? efficiency?
market?
Contestable Any number Differentiated No – in a Depends Low if the High – the High –
market is possible products are a contestable on the market is strength of competitive
key part of market, degree of highly competition pressures
non-price entry and actual contestable is likely to likely to get
competition exit costs competition – new firms encourage firms to
are low and the may be able firms to price control
threat of to enter the competitively their costs.
new cream skim
competition any
supernormal
profits

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 Monopolistic Fragmented Differentiated No entry Limited Supernormal Price > MC Possible
competition market – products barriers pricing profits therefore not loss of
many power e.g. competed allocatively productive
competing if there are away by the efficient efficiency if
suppliers many close entry of new market is
substitutes products saturated
with many
products
Monopoly A market Branded Entry Strong Supernormal Price > MC Scope for
dominated products barriers pricing profits therefore not economies
by one or a important power maintained allocatively of scale
handful of in including by entry efficient e.g. in the
firms protecting option to barriers case of a
market price Regulation natural
power discriminate may limit monopoly
monopoly
profit
Oligopoly Highly Branded High entry Strong Supernormal Price > MC Scale
concentrated products barriers price power profits therefore not economies
market – top help maintained allocatively possible
five firms maintain by entry efficient and although
have > 60 market barriers risk of also a risk
percent of dominance welfare loss of X-
market share of leading from price inefficiency
firms collusion
Perfect Many firms Homogeneous No entry No one Normal Allocatively Limited
competition none of products barriers at firm has profits in efficient as scale
which have (completely all price long run price = economies
any standardized) setting equilibrium marginal but
significant power – cost productive
market share they are efficiency
price takers in the long
run
equilibrium

Market Power

What is meant by market power?

• Market power occurs when businesses can influence market price without losing a high proportion of
sales
• When there are only a few close substitutes in a market then the cross price elasticity of demand will
be low
• This allows established businesses to set higher prices and achieve increased supernormal profits

Barriers to entry and exit then help to sustain market power of existing firms in the long

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4.1.5.2 The objectives of firms

Key specification content:

• A key starting assumption is that firms maximise profits
• Profit maximisation occurs where MC=MR
• For various reasons there may be a divorce of ownership from control and this has consequences
on objectives, conduct and performance
• Firms may have objectives other than profit maximisation, such as survival, growth, quality,
maximising sales and revenue and increasing market share
• Firms may also satisfice

Summary of objectives

Sales Revenue Business Growth / Business Survival in

Profit Maximisation
Maximisation Market Power a Recession

Profit Profits are maximised at an output level where marginal cost = marginal revenue
maximisation (MR=MC)
Revenue Revenues are maximised at an output where marginal revenue = zero
maximisation
Sales (volume) Supplying the largest output possible consistent with earning at least normal profits
maximisation where AR=AC
Satisficing Satisficing involves the owners of a business (shareholders) setting minimum
behaviour acceptable levels of achievement of either revenue or operating profits

Reasons for Different Objectives (Goals)

• Managerial objectives / managerial utility

o Revenue or sales growth is often preferred instead of profit maximisation
o Achieve a satisfactory profit / return for shareholders to reward them for risk-taking

• Information constraints / gaps

o Lack of accurate information on marginal cost & revenues in their markets
o Cost-plus pricing (AC + variable profit) is a common tactic – i.e. add a simple mark-up on
the average cost, with the mark up being higher if demand is found to be price inelastic

• Small businesses / start-ups - different aims

o Many small firms are “life-style businesses” for owners
o Start-ups often target rapid growth of users rather than profit

• State-owned corporations
o State-owned corporations are likely to have a range of different economic and political
objectives

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Profit Maximisation
• Profit maximisation occurs at an output where marginal revenue = marginal cost (MR=MC)
• The change in revenue from producing an extra unit of output = the change in cost from producing
an extra unit

Quick question

Take a look at the business pages in a reputable newspaper or news website. There is often information
on the latest profits and accounting figures of well-known companies. Jot down a few notes on which
companies appear to be profitable and which appear to be struggling. Can you think of reasons why this
might be the case?

Common error alert!

Economics students often confuse revenue with profit, assuming that a rise in demand will always, for
example, lead to a rise in profits. Unfortunately, it is impossible to assume this! If you only have information
relating to revenue, then you can only consider the impact on revenue – without additional information
relating to costs, you cannot confidently say anything at all about profit!

A reminder - marginal profit and profit maximisation

Profit maximisation occurs where MC = MR

Price, MC
Cost Profit
maximised
here

Marginal
profit is
negative
Marginal
profit is
positive

MR

Q1 Output

• Firms producing differentiated products choose price and quantity to maximise their profits,
considering the product demand curve and the cost function
• If MR > MC, the firm could increase profit by raising output – look on the diagram above, where you
should be able to see that this occurs at output levels less than Q1
• If MR < MC, the marginal profit is negative. It would be better to decrease output. On the diagram
above, this occurs at all output levels above Q1

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Analysis diagram showing price, output and profit when profits are maximised

Price
and
Cost MC

P1
AC

C1
AR
MR

Q1 Output

At profit maximising level of output Q1, the price given by the demand curve (remember this is the same as
the AR curve) is P1. Price x quantity gives total revenue. At level of output Q1, average total cost is C1. C1 x
Q1 gives total cost. The difference between these two rectangles on the diagram gives profit.

Benefits and drawbacks of businesses aiming to maximise profits rather than pursue alternative objectives

Benefits from aiming to maximise profits:

1. Shareholders are likely to benefit from higher dividends (a share of profits)
2. Employees may gain if some part of their pay is linked to the profitability of the business
3. Higher profits may lead to increased capital investment spending which will benefit other businesses
in industries such as engineering and construction
4. Businesses may choose to ‘plough back’ profits into R&D, leading to dynamic efficiency and improved
products/processes
5. Provides a safety net for businesses in tough times or recession

Drawbacks from aiming to maximise profits:

1. Higher prices for final consumers which reduces their real incomes / purchasing power and means a
lower level of consumer surplus
2. High profits might act as an incentive for new firms to enter the market – depending on how
contestable it is – which in the longer term might reduce the returns to shareholders as competition
intensifies
3. Companies that become overly focused on maximising profits might lose sight of the social / ethical
and environmental aspect of businesses to the detriment of local communities.
4. If profits are increased by pushing costs lower then this could impact on quality

Loss minimisation
Losses are minimised at the same output as profit maximisation – the same condition applies i.e. firms making
a loss should produce at an output where marginal revenue = marginal cost.

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 Price MC
and
Cost
AC

C1

P1

AR
MR

Q1 Output

Revenue Maximisation
• The objective of maximising sales revenue rather than profits was developed by economist William
Baumol whose work focused on the decisions of manager-controlled businesses
• His research found that salaries & rewards for mangers were closely linked to sales revenue rather
than profits
• A business might also aim to maximise sales revenue rather than profits because it wishes to deter
the profitable entry of new firms / rivals into an industry and therefore maintain more market power
• If a firm decides to aim to maximise sales revenue rather than profits, one consequence of this can
be a reduction in the price of the firm’s shares since operating profit is likely to be lower

Quick question

Remind yourself of how PED changes along a demand curve: where is it elastic? Inelastic? Unitary?

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Total revenue is maximised at a price and output where marginal revenue = zero.

Price Revenue Max: MR=0 Total Revenue

and
Cost
MC

P1 AC

C1

AR

Output
Profit Max: MC=MR MR

It is worth being aware of the other important aspects to the revenue-maximising level of output. MR is zero
at the ‘halfway’ point along the AR curve; this is also the point where PED is unitary (i.e. equal to -1).

Sales (volume) Maximisation

• The sales maximising output is when a business maximises output without making a loss
• Sales maximisation is at an output where AR=AC
• At this output, normal profits are made – i.e. just enough profit to keep a firm in a market in the long
run
• This objective tends to coincide with the objective of aiming to maximise market share

Output Total Average Total Cost Average Marginal Total Profit

Revenue Revenue Cost Cost
0 0 20 -20
1 50 50 50 50 30 0
2 90 45 72 36 22 18
3 120 40 87 29 15 33
4 140 35 116 29 29 24
5 150 30 150 30 34 0
6 150 25 198 33 48 -48

In this example, sales maximisation / maximising market share occurs at an output of 5 where AC and AR both
equal £30

Sales volume maximisation is also shown in the following analysis diagram:

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 Price Sales Max is at an output where AR=AC
and At this output, normal profits are made
Cost
MC

AC

P1

AR

Profit Max: MC=MR Q1 Output

MR

Common error alert!

If you also study Business, then you might feel slightly confused at this point! In Business, reference to ‘sales’
is exactly the same as referring to ‘revenue’. For an economist, when discussing revenue maximisation and
sales maximisation, these are different things!

Satisficing behaviour by firms

What is satisficing?
• Maximisers behave in a traditional economic way and always try to make the best possible choice
from all available alternatives (the implicit assumption being made here is of rational choice)
• Satisficers examine only a limited set of alternatives, and choose the best option between them
• Satisficing is generally concerned with ‘keeping a range of stakeholders happy’ and ensuring that the
business is earning ‘enough’ profit to do so
• Many businesses who adopt satisficing use simple rules of thumb rather than complex pricing policies.
Instead of trying to find the optimum profit-maximising price and output, they rely on simpler “cost
plus approaches” e.g. they charge the unit cost of supply + 10%
• Satisficers might be the managers of a business who are more concerned with increasing sales
revenue and/or their market share instead of seeking pure profit maximisation.

Price, output and profit with satisficing behaviour

• There is no unique profit satisficing output. It can occur at any output between profit maximisation
and sales maximisation. The firm is sacrificing some total profit but perhaps gains in other objectives
such as revenue and/or an increase in market share

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 Price
Possible satisficing price
and
Cost MC

P1
AC
P2

C2

AR
MR

Q1 Q2 Output

Market Share as a Business Objective

• Many businesses aim to increase or protect their market share. This is particularly true in oligopolistic
markets which is a market dominated by a handful of large businesses.

Divorce between Ownership and Control & the Principal Agent Problem

Shareholders and Stakeholders in a Business

• Stakeholders:
o A stakeholder is any individual or organisation who has a vested interest in the activities and
decision making of a business
• Shareholders:
o Own the business – they have an equity stake in the business - perhaps a founder
o May also work in the business
o Mainly interested in growing the value of their shareholding
§ Capital gain – an increase in the market value of a share
§ Dividends – a share of the profits made by a business

What Stakeholders Are Interested In

Stakeholder Mainly interested in:

Shareholders / Return on investment + profits and dividends
Owners Success and growth of the business
Proper running of the business

Managers & Rewards, including basic pay and other financial incentives
Employees Job security & working conditions
Promotion opportunities + job satisfaction & status – motivation,
roles and responsibilities

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 Customers Value for money
Product quality & customer service
Suppliers in the Continued, profitable trade with the business
market Financial stability – can the business pay its bills?
Banks & other Can the business repay amounts loaned or invested?
finance providers Profitability and cash flows of the business
Growth in profits and value of the business

Government The correct collection and payment of taxes (e.g. VAT)

Helping the business to grow – creating jobs
Compliance with business legislation
Local community Success of the business – particularly creating and retaining jobs
Compliance with local laws and regulations (e.g. noise, pollution)

Potential Conflicts between Stakeholders

Business Decision Likely to be Possibly

Supported By Opposed By?
Cut jobs to reduce costs Shareholders Employees
Banks Local community
Add extra shifts to increase factory Management Local community
capacity Customers & suppliers
Introduce new machinery to replace Customers Employees
manual work Shareholders
Increase selling prices significantly to Shareholders Customers
improve profit margins Management

The Divorce between Ownership and Control

In most businesses there is a divorce between ownership and control. In other words, the owners of a business
may not be the same people as those who are taking key day-to-day decisions.

Agency problem Possible conflicts of interest that may result between

shareholders (principal) and the management
(agent) of a firm
Stakeholders In most businesses there are many different
stakeholders. These include customers, managers,
employees, shareholders, debt holders and the
government
Stakeholder conflict Stakeholder conflict occurs when different
stakeholders have different objectives. Firms have to
choose between maximizing one objective and
satisfactorily meeting several stakeholder objectives,
so called satisficing

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Principal Agent Problem
The principal agent problem is an asymmetric information problem. The owners of a firm often cannot observe
directly the day-to-day decisions of management. Decisions and performance of the agent are costly and
difficult to monitor.
• Principal
o Owner of the business
• Hires an agent
o e.g. sales or finance manager
• Managers
o May have different business objectives

Overcoming The Principal Agent Problem

What is in the best interest of the management is not necessarily the same as what is in the optimum interests
of the shareholders. Strategies involve trying to align the aims of these two different stakeholders.
• Employee share ownership schemes
o John Lewis and Waitrose have a highly-regarded partnership model
o Stock options might lead to perverse behaviour – e.g. deliberate attempts to hike up share
prices through illegal action (think back to the case of Enron)
• Long term employment contracts for senior management
o Security of tenure might encourage managers to take decisions in the long term best
interests of the business
• Long term stock commitment
o Apple’s new policy (2013) requires senior executives at Apple to hold three times their annual
base salary in stock, and executives have to keep this salary in stock for a minimum of five
years to satisfy the requirement

Activist shareholders
• Activist shareholders look to put pressure on existing management or force through changes to
management boards.
• Some insist on businesses using profits to buy-back shares to increase returns to existing shareholders.
• An activist shareholder uses an equity stake to put pressure on existing management.
• The goals of activist shareholders can range from financial (e.g. increase of shareholder value through
changes in dividend decisions, plans for cost cutting or investment projects etc.) to non-financial (e.g.
dis-investment from particular countries with a poor human rights record, or pressuring a business to
speed up the adoption of environmentally friendly policies and build a better reputation for ethical
behaviour, etc.)

The Divorce between Ownership & Control and Business Conduct / Objectives

What is Meant by “Short-Termism”?

• Short-termism is where a commercial business prioritizes short-term rather than long-term
performance
• Short-termism emphasises certain performance measures:
o Share price (if the company is listed on a stock exchange)
o Revenue growth
o Gross & operating profit
o Low unit costs & improved productivity
o Rate of return on capital employed
• This might be at the expense of success in meeting longer-term business objectives:
o Market share

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 o Quality of product / service
o Research and innovation
o Brand reputation
o Employee skills & experience
o Social responsibility & sustainability

Possible Indicators of Short-termism

• Bonuses based on short-term objectives
• Low investment in R&D
• High dividend payments rather than reinvesting profits
• Overuse of takeovers rather than internal growth

Quick question

Can you think of other ‘real world’ business objectives that businesses might choose to pursue?

Quick question

Take a look at the business news. Can you find examples of businesses that you think are focused on:
- Profits
- Revenue
- Market share (sales volume)
- Satisficing
- Another objective of your choice?

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4.1.5.3 Perfect competition

Key specification content:

• Diagrammatic analysis in the short and long run
• The assumptions for perfect competition and the consequences in terms of behaviour, efficiency
and the allocation of resources
• Firms in perfect competition are price takers.

Many small bakeries in a Small-scale wheat

Sporting Bets
large city growers

Flower sellers at a Fruit seller in a big street Multiple bars in Spanish

wholesale market market tourists resorts

Perfect competition describes a market structure whose assumptions are strong and therefore unlikely to exist
in the vast majority of real-world markets. We can however take some insights from studying a world of perfect
competition and comparing and contrasting with imperfectly competitive markets and industries. Perfect
competition provides a yardstick for judging the extent to which real world markets perform efficiently and
the extent to which a misallocation of resources occurs.

Assumptions of a perfectly competitive market:

1. Homogenous (identical) products (they are all perfect substitutes) – there is no product differentiation
at all
2. All firms have access to the same quality factors of production
3. Large number of buyers & sellers and all sellers act independently (i.e. no price collusion)
4. Free (costless) entry into and exit from the market i.e. no barriers to entry or exit
5. Perfect knowledge / information for buyers and sellers
6. Profit maximisation is assumed as the key objective of firms – and consumers are assumed to be utility
maximisers when making their purchasing decisions

Key point: If there are many firms producing identical products, and consumers can easily switch from one
firm to another, then firms will be price-takers in equilibrium. They will have to accept the prevailing market
price.

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Profit maximisation in the short run – diagrammatic analysis

• When drawing perfect competition diagrams, remember to make a clear distinction between the
market and a representative individual firm i.e. you must draw two diagrams
• The market price is set by the interaction of market supply and demand
• Each individual firm is a price taker in a perfectly competitive market
• The ruling market price becomes the AR and MR curve for the firm
• Average revenue equals marginal revenue at every level of output
• We assume that the aim of each firm is to find a profit-maximising output

Price, Market Supply and Price, Revenues, Costs and Profits for a
Cost Demand Cost Competitive Firm

S
MC
Supernormal
profits
AR=MR
P1

AC
C1

Output Q1 Output

Examiner tip:
Firms can also make losses in the short run in perfect competition – this will happen if the ruling market price
is less than the average cost for a particular firm. Practice drawing diagrams in which the individual firm is
initially making a loss rather than earning supernormal profit. This causes firms to leave the industry, raising
the market price. Sub normal profits are shown below.

Sub-normal profit (economic losses) in the short run in perfect competition

Price, Market Supply and Price, Revenues, Costs and Profits for a
Cost Demand Cost Competitive Firm

MC

S AC

C1

P1
AR1 = MR1

Output Q1 Output

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Exam technique: Chain of reasoning:
Question: When will a firm consider shutting down production?

In the short run, a Variable costs are costs Providing that price per
business will continue to that vary directly with unit (AR) > average
supply products as long output such as raw variable cost (AVC), then
as their revenues at materials, component a contribution is being
least cover variable parts and employees made to cover some
costs. Revenue = AR x Q. paid an hourly wage. fixed (overhead) cost

This is because not But, if there is a fall in As a result the firm

enough revenue is being demand and price drops would be better off
generated and total below AVC, then a firm continuing production if
losses suffered would be might decide to shut- we assume that fixed
higher if production down production to costs are lost if a shut-
continued. minimise their losses. down decision is made

Profit maximisation in the long run – diagrammatic analysis

• If most firms are making abnormal (supernormal) profits in the short run, this encourages the entry
of new firms into the industry driven into the market by the profit motive
• This will cause an outward shift in market supply forcing down the ruling market price
• The increase in market supply will eventually reduce the ruling market price until price = long run
average cost
• At this point, each firm in the industry is making normal profit where price (AR) = average cost
• Other things remaining the same, there is no further incentive for movement of firms in and out of
the industry and a long-run equilibrium is established where price = average cost at output where
MR=MC

Price, Market Supply and Price, Revenues, Costs and Profits for a
Cost Demand Cost Competitive Firm

S1
MC

S2
AR1=MR1
P1

AC

P2
AR2=MR2

Output Q2 Output

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Long run equilibrium in perfect competition
• In long run equilibrium, all firms are making normal profits (P=AC)
• Normal profits where AR=AC – i.e. just enough profits to keep resources in their current use

Price, Market Supply and Price, Revenues, Costs and Profits for a
Cost Demand Cost Competitive Firm

S1
MC

S2

AC

P2
AR2=MR2

Output Q2 Output

How sub-normal profits affects the adjustment to market equilibrium in the long run

Price, Market Supply and Price, Revenues, Costs and Profits for a
Cost Demand Cost Competitive Firm

S2 MC

S1 AC

P2

P1
AR1 = MR1

Output Q1 Output

Firms making sub-normal profits are likely to leave the industry. This causes an inward shift of market supply
which then leads to a rise in the market equilibrium price. In the long run the net exit of firms will allow the
remain firms to earn normal profits where price = AC.

Economic efficiency in perfect competition

Allocative efficiency:
In both the short and the long run, price is equal to marginal cost (P=MC) and thus allocative efficiency is
achieved.

Productive efficiency:
Productive efficiency occurs when the equilibrium profit maximising output is supplied at minimum average
cost. This is attained in the long run for a competitive market. Output is at lowest point of AC. If a firm is

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producing at the lowest point of their lowest average cost curve this also means that the firm must be X
efficient

Dynamic efficiency:
We assume that a perfectly competitive market produces homogeneous products – in other words, there is
little scope for innovation designed to make products differentiated from each other and allow one or more
suppliers to establish monopoly power. Furthermore, the lack of any supernormal profit suggests that firms
will not have the funds available to reinvest. Therefore firms in perfect competition are unlikely to be
dynamically efficient.

Why competitive markets are good for economic efficiency

1. Lower prices because of many competing firms. The cross-price elasticity of demand for one product
will be high suggesting that consumers are prepared to switch their demand to the most competitively
priced products in the marketplace.
2. Low barriers to entry – the entry of new firms provides competition and ensures prices are kept low
3. Lower total profits and profit margins than in monopoly
4. Greater entrepreneurial activity. For competition to be improved and sustained there needs to be a
genuine desire on behalf of entrepreneurs to innovate and to invent to drive markets
5. Competition will ensure that firms move towards productive efficiency and avoid X inefficiency
6. The threat of competition should lead to a faster rate of technological diffusion, as firms have to be
responsive to the changing needs of consumers. This is known as dynamic efficiency.

Evaluating Assumptions of the Perfect Competition Model

1. Most firms have some amount of price-setting power – they are price makers not price takers!
2. Dominance in real world markets of differentiated / branded products
3. Highly complex products, there always information gaps facing consumers
4. Impossible to avoid search costs even with the spread of digital/web technology
5. Patents, control of intellectual property, control of key inputs are all ignored by the perfect
competition model
6. Rare for entry and exit in an industry to be costless
7. The model of perfect competition also assumes that there are no externalities (positive or negative);
in reality, there are often 3rd party effects of every market

General pros and cons of perfectly competitive market structures

Other than the points made above in relation to efficiency and the unrealistic underlying assumptions, other
positive comments that can be made in relation to the outcomes in perfect competition include:
• Consumers are not exploited by firms, in terms of high prices
• Equality – products are the same regardless of where they are bought, so all consumers are able to
buy the same product
• No ‘wasted’ costs in terms of advertising etc.

However:
• Consumers face a lack of choice, and cannot necessarily find a product that perfectly meets their
needs
• Firms are unlikely to be able to grow large enough to benefit from economies of scale

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4.1.5.4 Monopolistic competition

Key specification content:

• Diagrammatic analysis in the short and long run
• The main characteristics of these markets
• Monopolistically competitive markets will be subject to non-price competition

Characteristics of monopolistically competitive markets

Shoe repairs and key Taxi and minibus Sandwich bars and
makers companies coffee stores

Dry-cleaners and
Hairdressing salons Bars and Nightclubs
launderettes

What is monopolistic competition?

• Monopolistic competition is a form of imperfect competition and can be found in many real-world
markets ranging from sandwich bars and coffee stores in a busy town centre to pizza delivery
businesses in a city or hairdressers in a local area.
• Monopolistic competition is similar to perfect competition, indeed some economists regard it as more
realistic, because the products are differentiated
• Product differentiation means that businesses have some control over their products, it implies that
firms have some price-setting power, i.e. the AR curve slopes downwards

Key assumptions
• Many buyers and sellers – the industry concentration ratio is low
• Perfect information
• Very low barriers to entry/exit – this allows firms to respond to profit signals
• All products are in the same ‘market’ but are slightly differentiated i.e. consumer think that there are
some ‘non-price’ differences between products
• Firms aim to maximise profit; consumers aim to maximise utility
• Firms have a little price-making power over their own brand

Examiner tip:

In an exam, remember to write that a market structure is monopolistically competitive, not monopolistic, to
avoid confusion with monopoly!

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Profit maximising equilibrium in the short run – diagrammatic analysis
Price
and
Cost MC

P1 AC

Supernormal
Profit

C1

AR

Q1 Output
MR

This diagram is effectively the same as the monopoly diagram.

Profit maximising equilibrium in the long run

• Unlike monopoly, in monopolistic competition there are no barriers to entry and exit of firms in the
long run
• Supernormal profit in the short-run will therefore attract new suppliers offering new products and
therefore only normal profits can be made in the long run equilibrium i.e. where AR = AC
• As more firms enter the market, the demand curve for an existing firm shifts to the left as some
consumers opt to buy products offered by new or alternative companies
• The demand curve therefore moves to the left until it is tangential to the AC curve. The MR curve will
also shift inwards with the AR curve
• At this point, the monopolistically competitive firm is at its profit-maximising level of output (because
MR = MC) but it is also making only normal profit (because AR = AC)

Price In the long run equilibrium,

and average revenue is tangential
Cost to AC – meaning normal profits MC
are being made because P=AC

AC

P2

AR2

Q2 Output
MR2

Examiner tip: This diagram can be tricky to draw – therefore it needs a lot of practice before the exam!

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Monopolistic competition and economic efficiency
To what extent does monopolistic competition lead to economically efficient outcomes?
• Prices are above marginal cost – meaning that the market equilibrium is not allocatively efficient
• Saturation of the market may lead to businesses being unable to exploit fully internal economies of
scale - causing long-run average cost to be higher – therefore not productively efficient
• Critics of heavy spending on marketing and advertising argue that this spending is wasteful and an
inefficient use of scarce resources.
• Debate over the social costs of packaging and negative externalities from packaging waste is linked
to monopolistic competition
• Monopolistic competition associated with extensive consumer choice and innovation – this good for
dynamic efficiency although lower profit margins may reduce the funds available for research and
innovation

Monopolistic competition in the UK retail clothing market:

Leading retailers' share of the apparel market in the United Kingdom in 2008 and 2018
2018* 2008

Share of apparel market

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

M&S 7.6%
9.7%
Primark 7%
4.4%
Next 6.6%
6.7%
Arcadia 3.8%
5.3%
Asda 3.5%
3.5%
TK Maxx 3.1%
2.2%
Tesco 2.9%
2.5%
JD Sports 2.7%
1.1%
Debenhams 2.7%
3.3%
Sports Direct 2.4%
1.3%

In this example, the 3-firm concentration ratio is 21.2% and the 5-firm concentration ratio is 28.5%. This is well
below the C5 concentration ratio of sixty per cent needed for a market to be an oligopoly.

Firms in retail clothing sector will use a range of different types of non-price competition to drive sales and
protect their market share – these include:
1. Efficiency and ease of use of online ordering, collection and delivery
2. Making clothing available in a wider range of sizes
3. Customisation of product e.g. personalisation of tee-shirts and trainers
4. Returns policies for customers wishing to bring back purchases
5. Outlet shops to offer some excess stock at discounted prices
6. Effective use of social media such as Instagram
7. Taking steps to address corporate social responsibility including reducing waste associated with fast
fashion

Examiner tip

Be prepared to work out the concentration ratio for an industry using the data provided for easy marks!

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Exam technique: Example analysis/evaluation paragraphs:
Question: Assess the extent to which monopolistic competition leads to economic efficiency

Example KAA Point: Example Evaluation Point:

In monopolistic competition, we assume However, firms in monopolistic competition
that there are many firms each selling still have pricing power since AR and MR
slightly differentiated products and the are downward sloping. This is especially
barriers to entry are low. An example true for firms with strong brand loyalty.
might be many sandwich shops competing Even if the entry of new firms & products
in a city centre. Intense competition means that normal profits are made in the
between suppliers means that demand is long run, price will remain above marginal
likely to be price elastic (Ped>1) which then cost so allocative efficiency is not achieved.
means that prices may move closer to The saturation of many differentiated
marginal cost. Therefore, in contrast to a products in monopolistically competition
monopoly, prices for consumers will be may also lead to a loss of productive
lower and this would be an improvement efficiency as firms are unable to fully
in allocative efficiency of scarce resources. exploit economies of scale in the long run.

Quick question

Think about your local high street or shopping centre. How many examples of firms in monopolistically
competitive market structures can you think of?

Quick question

Compare and contrast perfect competition with monopolistic competition. Remember to think about
impacts on consumers, the firms themselves, suppliers, the government, the environment, and any other
stakeholders you think might be relevant.

Common error alert!

When drawing the long-run diagram, remember that the difference between the SR and the LR is that
demand for each firm has fallen (as more firms have entered the market, attracted by the supernormal
profits) i.e. AR and MR shift to the left. It can be tempting to think that the cost curves have shifted, because
the diagram is fiddly to draw!

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4.1.5.5 Oligopoly

Key specification content:

• Characteristics of oligopoly and possible variation in terms of number of firms, degree of product
differentiation and ease of entry
• Oligopoly can be defined in terms of market structure or conduct.
• Concentration ratios
• The difference between collusive and non-collusive oligopoly and collusion may allow firms to act
as a monopolist and maximise joint profit.
• The difference between cooperation and collusion
• The kinked demand curve – as one model of oligopoly and an illustration of interdependence
• Reasons for non-price competition, the operation of cartels, price leadership, price agreements,
price wars and barriers to entry
• Factors influencing prices, output, investment, R&D and advertising in these industries
• The significance of interdependence and uncertainty
• The advantages and disadvantages of oligopoly
• Real world application

Characteristics of oligopoly
• An oligopoly is an imperfectly competitive industry where there is a high level of market
concentration.
• Oligopoly is best defined by the actual conduct (or day-to-day behaviour) of firms within a market
• A rule of thumb is that an oligopoly exists when the top five firms in the market account for more
than 60% of market sales i.e. the C5 concentration ratio is above 60 percent.
• Key features of oligopolistic industries include price rigidity, lots of non-price competition,
interdependent decision making, and some attempts to collude and fix price or perhaps share out
the market.

Oligopoly is a form of imperfect competition – some of the key assumptions are as follows:
i) A market dominated by a few large firms each with a significant / large market share
ii) High market concentration ratio
iii) Each firm supplies branded products, which may or may not be properly differentiated
• Petrol retailers sell identical products (petrol / diesel has to be the same at every retailer)…but
they try to attract consumers by making other products available to buy (e.g. sweets, milk,
newspapers) and also compete on location
• Some oligopoly markets sell products that are more noticeable differentiated e.g. coffee
shops, banks
iv) High barriers to entry and exit
v) Interdependent strategic decisions by firms (this is the crucial aspect of modelling oligopoly)

Meaning of Strategic Interdependence

• Strategic interdependence means that one firm’s output and price decisions are influenced by the
likely behaviour of competitors/rivals
• Because there are few sellers, each firm is likely to be aware of the actions of the others
• Decisions of one firm influence, and are influenced by, the decisions of other firms
• This causes oligopolistic industries to be at risk of tacit or explicit collusion which can lead to
allegations of anti-competitive behaviour
• In oligopoly, there is always a high level of uncertainty

Remember that when discussing oligopoly, it is vital that you refer to the concept of interdependence!

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Common error alert!

Whilst it is true that oligopolies are defined by there being a small number of dominant firms, it is also true
that there can be large numbers of firms in this market structure – just think of coffee shops in the UK, with
the major chains of Starbucks, Pret, Costa (now bought by Coca Cola) and Caffe Nero, along with thousands
of other independent or smaller chains. The key is to remember the dominance of a small number of firms
with the largest five firms having at least sixty per cent of the market.

It is also important not to assume that all firms in oligopoly are necessarily large.

The n-firm concentration ratio

• Market share is the proportion of total revenue in a market accounted for by a brand, product or
company.
• The concentration ratio measures the combined market share of the top ‘n’ firms in the industry.
• Market share can be by sales, employment or other indicators
• The value of ‘n’ is often 5 but may be 3 or any small number.
• If the top ‘n’ firms gain a high market share the industry is said to have become more highly
concentrated
• As a rule of thumb, if the 5-firm concentration ratio is greater than 60%, then we have an oligopoly
• An oligopoly occurs when a few large firms dominate a market

Common error alert!

Do not confuse a concentrated market with a contestable market!

Example of the concentration ratio – petrol retailing in the UK

This chart below shows the brand market share of motor fuel sold in petrol stations across the UK in 2017.
Tesco dominated the motor fuel market with the most fuel sold through its many high-volume petrol stations
throughout the country. Tesco, Sainsbury's, Morrisons and Asda, accounted for the majority of fuel sold by
volume in the UK during 2017. The number of independent petrol retailers has declined.

Market share
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%

Tesco 16.1%
15.2%
Shell 13.5%
11.4%
Sainsburys 10.3%
9.8%
Asda 7.6%
5.4%
Certas Energy * 2.8%
2.2%
Unbranded 0.9%
0.8%
Minor brands 0.7%
0.6%
Harvest Energy 0.5%

The 3 firm concentration ratio = 44.8% and the 5 firm concentration ratio = 62.5%

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Example of a changing concentration ratio - Market share of grocery stores in UK from January 2015 to
October 2018

Market share of grocery stores in UK from January 2015 to October 2018

Other Multiples 3.0

1.7
Iceland 2.1
5.2
Lidl 5.6
6.4
Aldi 7.6
10.3
Asda 15.3
15.4
Tesco 27.4

0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0

Oct 18 Jan-15

Non-collusive behaviour in an oligopoly

Non-collusive behaviour effectively means that firms do not work together, and instead they compete with
each other, either in terms of price competition and/or non-price competition.

All behaviour / conduct by businesses in an oligopoly is strategic and will depend on the key objectives of
businesses. These can vary:
• Maintaining a satisfactory rate of profitability
• Protecting market share
• Growing their user base
• Reacting to the decisions of rival firms

Non-price competition in an oligopoly

Quality of service Free Upgrades to

Innovation
including after-sales Products

Exclusivity / Loyalty
Branding and advertising Sales Promotions
Schemes

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Non-price competition involves firms focusing on:
• Quality of product
• Design, look and feel
• Environmental impact (many consumers want information on the ethical sourcing of raw materials)
• After sales services / availability and cost of replacement parts
• Other marketing factors such as branding and advertising

Non-price competition is a key aspect of oligopoly especially when prices are sticky/rigid between competing
suppliers (rigid prices is a common feature of firms in oligopoly)/

Advertisers ranked by traditional advertising expenditure in the United Kingdom in 2017

Spending (£ million) in 2017

0 50 100 150 200 250

Sky 197.1
Procter & Gamble 196.8
BT Ltd 144.1
Unilever 116.8
McDonald's 96.2
Tesco 89.5
Reckitt Benckiser 88.2
Virgin Media 72.1
Lidl 71.1
Samsung 66.6

Product branding is a really significant feature of non-collusive competition in all types of imperfect
competition but especially in oligopoly where building and maintaining market share is often a dominant
business objective.

Brands associated with specific products. Fast

Product brand moving consumer goods brands (FMCG) are some of
the best examples

Brands that add perceived value to services, either

Service brand delivered face-to-face or via online & apps

Brands that are assigned to more than one product.

Umbrella brand Makes different product lines easily identifiable by
the consumer

Promoting the brand name of a business as opposed

Corporate brand to specific products or services

A type of corporate branding where retail outlets

Own-label brand assign their corporate branding to a range of goods
and services

The ultimate brands - “household” names based on

Global brand familiarity, availability and stability that are effective
across global markets

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Reasons for collusive behaviour
Collusion is a form of anti-competitive behaviour. Collusion between businesses can be:
• Horizontal – between firms at the same stage of production
• Vertical – between businesses at different stages of production
• Explicit v tacit collusion (i.e. open v quiet collusion)

Collusion usually refers to businesses working together to agree to jointly set prices high and/or restrict output.
Key Aims of Business Collusion in an Oligopoly
1. Businesses in a cartel recognise their interdependence and act together – the aim is to maximise joint
profits
2. Collusion lowers the costs of competition e.g. wasteful marketing wars which can run into millions of
pounds
3. Collusion reduces uncertainty – and higher profits increases producer surplus / shareholder value –
leading to higher share prices

Legal forms of business collusion / cooperation

Not all instances of collusive behaviour are deemed to be illegal by the European Union (EU) Competition
Authorities.
1. Practices are not prohibited if the respective agreements "contribute to improving the production or
distribution of goods or to promoting technical progress in a market.”
2. Development of improved industry standards of production and safety which benefit the consumer
– a good example is joint industry standards in Europe for mobile phone chargers
3. Information sharing designed to give better information to consumers
4. Research joint ventures and know-how agreements which seek to promote innovative and inventive
behaviour in a market. The EU has introduced R&D Block Exemption Regulation for this situation.

Open (formal) collusion

• Overt means spoken, open or traceable i.e. firms have actively agreed to collude
• Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent
price and revenue instability in an industry.
• Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the
level we would expect from a monopoly.
• To collude on price, producers need some control over market supply, and have strong pricing-
making power

Conditions when price-fixing cartels are likely to happen in an oligopoly

Collusion through price-fixing and/or market sharing in an oligopoly is easier to achieve when:
1. Industry regulators are ineffective – this is an example of regulatory failure
2. Penalties for collusion are low relative to gain in profits - fines therefore do not act as a proper
deterrent
3. Few firms in the market and price inelastic demand (PED<1) – higher prices then lead to increased
revenues
4. Participating firms have a high percentage of total sales – this allows them to control market supply
5. Firms can communicate well and trust each other – this is helped by having similar strategic objectives
6. Products are standardised and output within the cartel is easily measurable so that supply can be
controlled
7. Brands are strong so that consumers will not switch demand when collusion raises prices
8. There are other strong barriers that prevent consumers from switching to other products / alternatives

Why do many price-fixing cartels eventually break down?

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 Entry of non-cartel Over-production
Economic recession Whistleblowers
businesses within the cartel

Cartels in an oligopoly frequently break down after a while – there are several possible causes of this:
• Enforcement problems:
o The cartel aims to restrict production to maximize total profits.
o But each individual seller finds it profitable to expand their production.
o Other firms who are not members of the cartel may take a free ride by selling under the
cartel price
• Falling market demand – for example during a recession – which creates excess capacity in the
industry and this then puts downward pressure on profits and cash-flow in the cartel
• The successful entry of non-cartel firms into an industry undermines a cartel’s control of the market
• The exposure of price-fixing by whistle-blowing firms – i.e. firms engaged in a cartel that pass on
information to the competition authorities in the hope of more lenient treatment from the regulatory
competition authorities

Collusion and economic efficiency / economic and social welfare

The UK Competition and Markets Authority (CMA) believes that cartels are damaging to economic efficiency
and economic welfare. They have argued that:

“Cartels are a major barrier to competition and can lead to significantly increased prices and reductions of
output, efficiency, innovation and choice, all of which are harmful to consumers.”

There are significant penalties for UK businesses found to be engaged in price-fixing cartels and other forms
of anti-competitive behaviour.
1. Businesses in breach of competition law can face fines of up to ten per cent of their worldwide
turnover.
2. Those convicted of a cartel offence can face up to five years of imprisonment, unlimited fines, director
disqualification for a period of up to fifteen years and potential confiscation of their assets.

Costs of Collusive Behaviour

• Damages consumer welfare
o Higher prices / lost consumer surplus
o Loss of allocative efficiency
o Hits lower income families – i.e. has a regressive impact

• Absence of competition hits efficiency

o X-inefficiencies leads to higher unit costs
o Less incentive to innovate / loss of dynamic efficiency
o Output quotas penalise firms who want to expand

• Reinforces the cartel’s monopoly power

o Harder for new businesses to enter the market – this reduces market contestability

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Potential Benefits from Collusion
• General industry standards can bring social benefits from
o Pharmaceutical research
o Improved car safety technology

• Fairer prices for producer cooperatives in lower and middle-income developing countries
o Competing more effectively with powerful corporations who have monopsony power
o This may help in reducing rates of extreme income poverty

• Profits have value – how are they used?

o Research and development – leading to dynamic efficiency
o Higher wages for employees – increased consumption

The kinked demand curve model

The kinked demand curve is one model of firm’s pricing behaviour in an oligopoly. The model assumes that:

• Firms sell homogenous products (or products that are very close substitutes)
• Firms compete on price
• Firms have predictable patterns of behaviour i.e. if one firm raises price then no others will, or if one
firm lowers price then all firms will copy that behaviour

The kinked demand curve shows that

price in an oligopoly is actually very
stable at price P. This is because if the
firm raises its price above P, then
demand will be very price elastic as
consumers will swap to buying
substitutes. If the firm lowers the price
below P, then demand will be very price
inelastic as other firms follow the move
(triggering a price war) and so there is
very little gain in quantity demanded.

In the kinked demand curve model, the associated MR curve is discontinuous i.e. it ‘leaps’ at the kink. When
demand is price elastic (i.e. the top part of the AR curve), a fall in price leads to a larger proportionate increase
in quantity demanded, which in turn results in an increase in total revenue. This means that in the elastic
portion of the AR curve, MR must be positive i.e. TR has risen. When demand is price inelastic (i.e. the bottom
part of the AR curve), a fall in price leads to a less than proportionate increase in quantity demanded, which
in turn results in a fall in total revenue. This means that in the inelastic portion of the AR curve, MR must be
negative i.e. TR has fallen.

A change in the firm’s costs, in this case, will have little impact on the price and output chosen. The diagram
that follows can be used to illustrate this point. The firm is aiming to profit-maximise, and so operates at a
level of output where MR = MC. Even if costs change, causing the MC/AC curves to shift up or down, they will
have to alter significantly for this to change the point where MC = MR.

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Evaluating the kinked demand curve model
Advantages:
• Explains the real-world observation that prices in an oligopoly are relatively stable over time
• Can be used to explain how price wars might occur
• Suitable for use in the small number of oligopolistic markets where products are relatively
homogeneous
Disadvantages:
• Not a particularly dynamic model i.e. does not help to explain how a new stable price might be
achieved, after firms have decided to lower or raise prices
• Does not consider the likelihood of collusion
• Not relevant for oligopolistic markets that sell differentiated products

Extension material: simple game theory – the Prisoner’s Dilemma

Game theory is not required for the AQA specification but is interesting and can bring depth to analysis or
evaluation.

What is game theory?

Oligopoly theory often makes heavy use of game theory to model the actual behaviour of businesses in
concentrated markets. Game theory is the study of how people and businesses behave in strategic situations
(i.e. when they consider the effect of other people’s responses to their own actions).

Summary of some key game theory concepts

Cooperative outcome An equilibrium in a game where the players agree to cooperate

Dominant strategy A dominant strategy is one where a single strategy is best for a player regardless
of what strategy other players in the game decide to use
Nash equilibrium Any situation where all participants in a game are pursuing their best possible
strategy given the strategies of all of the other participants

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 Tacit collusion Where firms undertake actions that are likely to minimize a competitive response,
e.g. avoiding price-cutting or not attacking each other’s market OR
Firms may end up raising prices but without ever having discussed it or reached
a formal collusive agreement
Whistle blowing When one or more agents in a collusive agreement report it to the authorities
Zero sum game An economic transaction in which whatever is gained by one party must be lost
by the other.

The Prisoner’s Dilemma

• The Prisoner’s Dilemma is a game that illustrates why it is difficult to cooperate, even when in the best
interest of both parties.
• Both players are assumed to select their own dominant strategies for personal gain.
• Eventually, they reach an equilibrium in which they are both worse off than they would have been, if
they could both agree to select an alternative (non-dominant) strategy.

Two prisoners are held in a separate room and they Prisoner A

cannot communicate
They are both suspected of a crime
They can either confess or they can deny the crime
Payoffs shown in the matrix are years in prison from
their chosen course of action. The payoff on the left in
each box represents Prisoner B and the payoff on the
Confess Deny
right in each box represents Prisoner A
Confess (3 years, 3 years) (1 year, 10 years)
Prisoner B Deny (10 years, 1 year) (2 years, 2 years)

How to interpret / read the matrix:

- Put yourself in the shoes of Prisoner A
- Assume that Prisoner B has decided to Confess to the crime
- In this case, Prisoner A would get 3 years in prison if she also confesses or 10 years if she denies it –
the rational choice here would be to Confess
- Now suppose that Prisoner B has decided to Deny the crime
- In this case, Prisoner A would get 1 year in prison if she confesses or 2 years if she denies it – the
rational choice here would again be to Confess
- In other words, Prisoner A has a dominant strategy – whatever Prisoner B chooses to do, it is always
better for Prisoner B to Confess
- The example above is a ‘symmetric payoff matrix’ i.e. the payoffs are identical, given identical
choices/strategies, for each Prisoner
- This means that Prisoner B’s dominant strategy is also to always Confess
- The two dominant strategies ‘intersect’ so that the Nash Equilibrium is for both Prisoners to Confess
– this gives them 3 years in prison each
- However, if they had been able to cooperate, it would have been better for them both to deny the
crime and receive just 2 years in prison…although this risks 1 of them ‘cheating’ on the agreement to
get themselves down to just 1 year in prison
- When both prisoners follow narrowly-defined self-interest, both actually end up making themselves
worse off

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Example of Game Theory – A Simple Pricing Game
The values in the table refer to the profits that flow from making a particular output decision. In this simple
game, the firm can choose to produce a high or a low output. This ‘game’ also follows a Prisoner’s Dilemma
format. The profit payoff matrix is shown below.

Firm B’s output

High output Low output
Firm A’s output High output £5m, £5m £12m, £4m
Low output £4m, £12m £10m, £10m

• Display of payoffs: row first, column second e.g. if Firm A chooses a high output and Firm B opts for
a low output, Firm A wins £12m and Firm B wins £4m.
• In this game, the reward to both firms choosing to limit supply and thereby keep the price relatively
high is that they each earn £10m. But choosing to defect from this strategy and increase output can
cause a rise in market supply, lower prices and lower profits - £5m each if both choose to do so.
• A dominant strategy is one that is best irrespective of the other player’s choice. In this case the
dominant strategy is competition between the firms.
• The Prisoner’s Dilemma can help to explain the breakdown of price-fixing agreements between
producers – this is because there is an incentive to ‘cheat’ because of the potential for higher profits.
This can lead to the outbreak of price wars among suppliers, the breakdown of other joint ventures
between producers and also the collapse of free-trade agreements between countries when one or
more countries decides that protectionist strategies are in their own best interest.
• The key point is that game theory provides an insight into the interdependent decision-making that
lies at the heart of the interaction between businesses in a competitive market.

In reality, it is very difficult to apply simple 2 x 2 payoff matrices (i.e. 2 firms with 2 strategies) as the world is
more complicated that that. It is also very difficult to work out what the possible payoffs might be, as a result
of different interdependent choices.

Game theory and the potential benefits from collusion

An industry consists of two firms, X and Y. The Profit-Payoff Matrix in the table below shows how the profits
of X and Y vary depending on the prices charged by the two firms:

Price charged by Business B

Price Business A = £20 Price Business A = £8

Price charged by Price Business A = £20 £12m A, £12m B £16m A, £-2m B
Business A
Price Business A = £8 £-2m A, £16m B £0m A, £0m B

• If both businesses chose to collude on price rather than act competitively, the two firms would be
able to increase their joint profits by £24m.
• However, if they agree to collude at the higher price of £20, there is an incentive for one business to
under-cut the other, charge a lower price of £8 and inflicts a small loss of -£2m on the other business,
whilst increasing their own profit (temporarily) from £12 to £16.

Evaluating the relevance of game theory

• Game theory becomes relevant to analysing business decision making when there are relatively few
firms

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 • Standard game theory assumes rational agents are looking to maximise their own self-interest
• More complex game theory reveals that people / businesses can develop co-operative and/or
collaborative behaviours e.g. the rise of joint ventures / altruism
• Key evaluation point for the exam: Game theory can over-simplify complex decisions, and when there
are more than two rival firms in a market the degree of complexity increases. Many firms fall back on
rules of thumb when making decisions on price, advertising budgets, production levels and much
else beside

Types of price competition

Price wars are common in oligopolistic markets as firms battle to secure market share at the expense of rivals.
We see many examples in markets as diverse as petrol retailing, food grocery, low-cost airlines and funeral
services.
Price wars may lead to short run increases in sales and revenues but may not be in the long-term commercial
interests of a business.

Low cost Petrol retailers Mobile phone Supermarkets Funeral Lunchtime

airlines tariffs services meal deals

Winners
• Regular consumers who will see an increase in consumer surplus
• Managers – sales revenues will increase if demand is price elastic (i.e. PED>1) which might lead to
higher sales bonuses
Losers
• Shareholders – if a prolonged price wars leads to lower profits
• Suppliers – who may get squeezed if a firm uses monopsony power to lower the prices of their
supplies – for example, farmers have complained that supermarket price wars have led to delays in
them getting payment
• Smaller firms - who may not be able to absorb possible losses from an intense price war
• The government - if lower profits causes a decline in corporation tax revenues

Pricing strategies
Here is a summary of pricing strategy common in concentrated markets where one or more firms have pricing
power:

Break-even price Break-even price is when price = average total cost (P=AC)
Cost-plus pricing Where a firm fixes the price by adding a fixed percentage profit margin to the
average cost of production
Limit pricing Limit pricing is pricing by a firm to deter entry or the expansion of fringe firms.
The limit price is below the short run profit maximising price but above the
competitive level
Peak pricing When a business raises its prices at a time when demand has reached a peak
might be justified due to higher marginal costs of supply at peak times
Penetration pricing Pricing policy used to enter a new market, usually by setting a low price
Predatory pricing Predatory pricing is a deliberate strategy of driving competitors out of the
market by setting low prices or selling below average variable cost.

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 Common error alert!

Do not confuse predatory pricing with price leadership.

Do not confuse limit pricing with predatory pricing.

Quick question

Why might different firms choose different pricing strategies? Can you think of any examples of each of
the strategies listed above?

Exam technique – building analysis paragraphs

Question: Explain how a firm may use limit pricing

Limit pricing is defined as pricing by the incumbent firm(s) to deter the entry or the expansion of fringe
firms. Limit pricing is a pricing strategy designed as a barrier to entry in order to protect a firm’s monopoly
power & supernormal profit. The limit price is below the normal profit maximising price but above the
competitive level. This is shown in my analysis diagram. The monopolist is charging a price lower than the
estimated AC for a rival. They are willing to sacrifice profits in the short run to prevent entry. As a result, the
potential rival firm may decide that the risks of entering the industry are too high – they may make a sizeable
loss and might not have the resources to sustain those losses until they can reach a competitive level of
average cost through scale economies. If limit pricing is successful, then a market is likely to remain highly
concentrated in the hands of one or a small number of dominant, businesses who can continue to earn
supernormal profit with P>AC.

Supporting analysis diagram:

Supporting Price & cost

analysis
diagram MC AC

P1
AC of rival
AC of rival
P2
If the new low price P2 is
below the estimated average C2
cost of the potential rival AR
firm, and assuming that firms
in the market sell at similar
MR
prices, then the rival firm
may face the risk of big
losses if they enter. Q1 Q2
Output

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Oligopoly Key Term Summary

Abnormal profit Any profit in excess of normal profit - also known as supernormal profit
Altruism Disinterested and selfless concern for the well-being of others
Collusive oligopoly When several large firms in an industry act to restrict price or output or share out the
market
Concentration ratio Measures the combined market share of threading firms in an industry
Duopoly Market dominated by two rival firms
Duopsony Two major buyers of a good or service in a market
First mover When a business can develop a competitive advantage through early entry into an
advantage industry
Interdependence When firms must take into account the likely reaction of rivals to changes in price
and output
Joint profit Price fixing with the aim of achieving an outcome associated with pure monopoly
maximisation
Limit pricing When a firm sets average revenue just low enough to discourage possible new
entrants
Non-price Advertising and marketing strategies to increase demand and develop brand loyalty
competition among consumers.
Price leadership When other businesses accept the p rice changes established by a dominant firm
Tacit collusion When businesses co-operate but not formally, e.g. quiet or implied co-operation

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4.1.5.6 Monopoly and monopoly power

Key specification content:

• Diagrammatic analysis of monopoly model
• Monopoly power is influenced by factors such as barriers to entry, the number of competitors,
advertising and the degree of product differentiation.
• Firms operating in monopolistically competitive and oligopolistic markets are price makers and
have varying degrees of monopoly power
• The advantages and disadvantages of monopoly

Characteristics of monopoly
• A pure monopolist is a single supplier that dominates the entire market
• In reality – the UK Competition and Markets Authority (CMA) deems that:
o A working monopoly is any firm with greater than 25% of the industries' total sales
o A dominant firm is a firm that has at least 40% market share
• Price-making power is available to any business with a downward-sloping demand curve
• There are assumed to be high entry and exit barriers into a monopoly market
• Firms in a monopoly, as in other market structures, aim to maximise profit (i.e. operate where MR =
MC)
• Because firms are price makers, they will have a downward-sloping demand curve (AR)
• If AR is falling, marginal revenue (MR) is below AR (and is twice as steep)

Domestic gas suppliers market share in the UK (1st quarter of 2018)

Here is an example of a working monopoly within an oligopoly. British Gas is leading in market share at 30
percent. The 'Big Six' energy supply companies in the United Kingdom combine 79 percent of the total market
share. A cluster of smaller gas suppliers such as Ovo Energy (which gets their gas from renewable sources)
are trying to erode the dominance of the largest operators.

35.0%
30%
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30.0%
25.0%
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15.0% 11% 11%
9% 9% 8% 8%
10.0%
5.0% 3% 3% 2% 2% 1%
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Examiner tip

There are few examples of pure monopolies i.e. 100% market share – bear in mind that one firm can be
dominant but that overall the market structure may be more like oligopoly. Assessing the market structure of
a given industry depends on how we define that market. For example, we could say that South Western
Railway has a monopoly on train travel between Hampshire and London, but if we broaden the market to be
travel using any mode between Hampshire and London then there is greater degree of competition e.g. using
National Express coaches, driving be car etc.

Profit maximisation for a monopolist

The table below shows the demand and cost conditions for a business with monopoly power. A monopolist
has price-setting power because they face a downward-sloping demand curve. If AR is falling, MR will be
below AR.

Remind yourself of how the data in each column should be calculated!

Price per Quantity Total Marginal Total Cost Marginal Average Profit
unit demanded Revenue Revenue Cost Cost
30 200 6000 2700 13.5 3300
28 240 6720 18 3100 10 12.9 3620
26 280 7280 14 3380 7 12.1 3900
24 320 7680 10 3580 5 11.2 4100
22 360 7920 6 3700 3 10.3 4220
20 400 8000 2 3780 2 9.5 4220
18 440 7920 -2 3900 3 8.9 4020
16 480 7680 -6 4100 5 8.5 3580
14 520 7280 -10 4380 7 8.4 2900

It is helpful to understand precisely why MR is less than AR. In simple terms, it is because that in order to sell
an additional unit, a firm is assumed to lower the price of all units sold and not just the marginal unit sold –
this is the case unless a firm is able to practise first degree / perfect price discrimination.

Analysis diagram to show profit maximisation for a monopolist

Price The average revenue

and is much higher than
Cost the unit cost at MC
output Q1
P1

AC
Supernormal Profit

The monopoly is
a price-maker
C1 AR
although it is
also constrained
by their demand
curve

Q1 Output
Profit Max: MC=MR MR

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Natural monopoly

What is a natural monopoly?

Price A natural monopoly there there are high

and fixed costs involved in supplying a good or
Cost service such that the long run average cost
curve may fall continuously as output
increases in the long run.
P1

AR
C1

LRAC

LRMC
MR

Q1 Output

A natural monopoly occurs when a large business can supply a market at a lower price than smaller ones. A
natural monopoly is a situation in which there cannot be more than one efficient provider of a good. It is an
industry where the minimum efficient scale is a large share of market demand.
• A natural monopoly is characterised by increasing returns to scale at all levels of output
• Thus, the long run cost per unit (LRAC) will drift lower as production expands
• LRAC is falling because long run marginal cost is always below LRAC
• There may be room only for one supplier to fully exploit economies of scale, reach the minimum
efficient scale and achieve productive efficiency

Examiner tip

The easiest way to understand this diagram is that the demand curve / AR / MR are the same as in any other
imperfectly competitive industry. The cost curves, on the other hand, have been ‘stretched out’ because of the
significant economies of scale.

Quick question

Can you explain why the following industries / firms could be considered examples of natural monopoly?
- British Airports Authority
- Royal Mail
- National Grid
- Network Rail

There is increasing interest in the rise of platform businesses such as Google, Amazon, Facebook and Netflix
– all of whom have grown rapidly and achieved economies of scale in their pursuit of market dominance.
Should economists be concerned about the economic and social consequences of these types of businesses?

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 Web Search Messaging E-Commerce Taxi apps Streaming Sharing
services economy
Exam Technique: Building a chain of reasoning:
Question: How is a natural monopoly different from other industries?

A natural monopoly is a This is because of the For example, the supply

special case where one nature of costs in a of water or electricity to
large business can natural monopoly houses and businesses
supply the entire market industry. Typically there involves building a big
at a lower unit cost than are very high fixed costs network infrastructure.
with multiple providers. and low marginal costs.

This means that long Therefore, the average As a result, fixed costs
run average cost (LRAC) total cost will continue are enormous but the
may fall across all ranges to fall as extra users are marginal cost of adding
of output. Only one firm added to the network. an extra user is very low
might reach the This is an internal
minimum efficient scale. economy of scale.

Examiner tip:

Use the natural monopoly argument as a theoretical and practical piece of evaluation for essays relating to
the pros and cons of monopoly i.e. if a natural monopoly did not exist in a particular market then it may be
the case that there would be a missing market. Furthermore, many natural monopolies operate in the national
interest. The quality of service provided makes a big difference to the everyday lives of millions of households
and businesses.

Quick question

Why might it be beneficial for firms that have the characteristics of natural monopoly to be nationalised, or
run in the public interest?

Economic efficiency in monopoly

The standard case against monopoly is that it is leads to a loss of economic efficiency which can then cause
reductions in the welfare of consumers affected. But this view can be challenged as part of your evaluation. It
is important to judge the exercising of market / monopoly power on a case-by-case basis based on how
businesses with such power actually conduct themselves.

Economic Case against Monopoly

i) Prices are higher than under competitive conditions
o This leads to a loss of allocative efficiency (because the monopoly price > MC)
o Higher prices can have a regressive effect on lower-income households
ii) Absence of genuine market competition may lead to production inefficiencies
o X-Inefficiencies such as wasteful production and advertising spending
iii) Higher prices can limit output in a market and lead to fewer economies of scale being exploited

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 iv) Protected markets mean that perhaps there is less drive to innovate – leading to less dynamic
efficiency
v) Monopoly may get too big – causing one or more diseconomies of scale – leading to rising long
run AC

Examiner tip

You do need to be able to compare and contrast market structures in terms of efficiency, both in theoretical
terms and in practical terms for example applying information that appears in data response questions.

Chain of reasoning on monopoly power

This means that, at the profit-

A monopoly supplier such a maximising level of output where
regional water utility has MR=MC, the monopoly price is
significant market power and can above marginal cost. This then
therefore set prices above the level leads to a loss of allocative
we would expect to see in a more efficiency meaning that scarce
competitive market. resources are not being allocated
optimally.

High monopoly prices lead to a

The monopolist makes abnormal
deadweight loss of consumer
(supernormal) profit (price > AC)
welfare because output is lower
but the loss of consumer surplus is
and price is higher than a
greater than the gain in producer
competitive equilibrium. Higher
surplus leading to a net loss of
prices mean some consumers are
welfare measured by community
priced out of the market because of
surplus
a fall in effective demand.

Analysis diagram showing welfare loss from monopoly pricing

There are reductions in consumer welfare when firms use their market power to raise price above a competitive
level.

Price Deadweight
and loss of welfare
Cost MC
= area ABC
A
P1
B
AC
Supernormal Profit

C1 AR

High monopoly price

can lead to a
Q1 Output
deadweight loss of MR
economic welfare

Economic Case for Monopoly Power

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High market concentration can reflect the success of firms in providing better-quality products, more
efficiently, than rivals. Some of the key advantages from monopoly include:
i) Profits can be used to fund investment & research
ii) Natural monopoly allows for the applications of economies of scale which leads to lower prices
iii) Domestic monopoly businesses often face global competition
iv) Monopolistic firms can be regulated – i.e. an industry regulator acting as a proxy consumer
v) Price discrimination may help some consumers if charged a lower price than the usual monopoly
price

Examiner tip:

Essays relating to the pros and cons of concentrated markets are incredibly common, especially when tied in
with the effectiveness of policies to reduce exploitation by firms in concentrated markets.

Evaluating monopoly power

• Natural monopoly – it might be more productively efficient to have a monopoly supplier
• Competition in the supply chain – possible to introduce competition at different stages of the supply
chain e.g. via competitive tendering, franchises
• “In theory …. But in practice”: Best to judge a monopoly on a case by case basis using an evidence-
based approach to how a monopoly actually behaves in the market. This is a really powerful
evaluation tool!
• Contestability – the threat of entry into a market can be a powerful influence on firms with monopoly
power
• Definition of the market – a business might have monopoly power in the domestic market but face
significant international competition

Monopoly Key Term Summary

Arbitrage Simultaneous buying and selling of securities, currency, or commodities in different markets
to take advantage of differing prices for the same asset.
Bi-lateral monopoly Where a monopsony buyer faces a monopsony seller in a market
Concentration ratio Measures the proportion of an industry's output or employment accounted for by the
largest firms
Dominant firm Business with more than 40 percent of market share
Entry barriers Strategies used to protect the market power of established firms whilst maintain
supernormal profits
Industry regulator Appointed by government to oversee how a market works and the outcomes that result for
producers and consumers
Legal monopoly A monopoly that is protected by law from competition e.g. through patents or government-
awarded franchise
Limit pricing When a firm sets price low enough to discourage new entrants into the market.
Market liberalisation Introducing competition in previously monopolistic sectors such as energy supply, retail
banking and postal services
Market power Power to raise price above marginal cost without fear of losing supernormal profits to new
entrants
Market Splits up a market into different types (segments) to enable a business to better target its
segmentation products to the relevant customers
Monopoly profit Supernormal profit to a firm with market power, achieved when price (AR) > average cost

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 Natural monopoly When long-run average cost (LRAC) falls continuously over a large range of output so only
one firm can fully exploit economies of scale
Predatory pricing A deliberate strategy of driving competitors out of the market by setting very low prices or
selling below AVC
Price discrimination Charging different prices to different groups of consumers for the same product for reasons
not associated with the marginal cost of supply
Pure monopoly The only supplier in an industry - with a 100 percent market share. The firm is the industry
Regulated A business with market power regulated through price-capping or some other form of
monopoly intervention
Third degree price Charging different prices for the same product in segments of the market. Price is linked
discrimination directly to consumers' willingness and ability to pay for a good or service
Welfare loss Overall reductions in consumer welfare when firms use their market power to raise price
above a competitive level
Willingness to pay The maximum price at or below which a consumer will definitely buy one unit of a product.
Working monopoly Business with more than 25 percent share of a defined market
X-inefficiency When the lack of competition leads to higher average costs than necessary to supply a given
level of output

Extension material - Monopsony

Characteristics and conditions for a monopsony to operate

Supermarkets National Health Energy British Sugar Amazon Food

Service generators manufacturers

What is monopsony power in product markets?

• A monopsony has buying or bargaining power in their market.
o Note that this is different to a monopoly, which has dominant selling power
• This buying power means that a monopsony can exploit their bargaining power with a supplier to
negotiate lower prices.
• The reduced cost of purchasing inputs increases their profit margins
• Examples of monopsony power in a market:
o Electricity generators negotiate lower prices for coal contracts
o Food retailers have power when sourcing/purchasing supplies direct from farmers, milk
producers, wine growers and other suppliers
o Low-cost airlines getting a favourable price when purchasing aircraft
o British Sugar buys almost the entire sugar beet crop produced in the UK
o The government is a major buyer e.g. in military procurement
o The UK National Health Service is another example of a dominant buyer of prescription drugs
from the pharmaceutical companies.

Chain of reasoning: Monopsony power and the effect on consumer welfare

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 A monopsony has This means that a As a result, their
buying or bargaining monopsony (in theory) variable costs of
power. For example, can use their purchasing production will be lower
retailers have power power to negotiate and this will lead to a
when purchasing lower prices for raw decrease in marginal
supplies from farmers materials & other inputs and average total costs.

This assumes that the In this way, final If the monopsony is a

price paid by the consumers may benefit profit-maximising firm,
consumer is the main from lower prices which then a fall in AR and MC
determinant of their will therefore increase (ceteris paribus) will
welfare. This may not be their consumer surplus lead to lower
the case in reality. and economic welfare. equilibrium price..

Costs and benefits of a monopsony to firms, consumers, employees and suppliers

Benefits to firms:
1. Monopsony power allows bigger firms to achieve purchasing economies of scale leading to lower
long run average costs
2. Lower purchase costs bring about higher profits and increased returns for shareholders
3. The extra profit might be used to find capital investment or research and development

Benefits to consumers:
1. Consumers gain from lower prices e.g. supermarkets negotiate better prices from manufacturers that
are then passed on to consumers
2. Improved value for money – for example the NHS can use its bargaining power to cut the prices of
drugs used in treatments. Cost savings allow for more treatments within the NHS budget

Drawbacks from monopsony power

1. Businesses may use their buying power to squeeze lower prices out of suppliers. This reduces the
profits of firms in the supply chain and causes lower incomes
2. A recent example has been the battle of milk farmers to get a higher price from supermarkets that
covers the average cost of their milk (i.e. avoid subnormal profits, threat of closure)
3. Consumers might be faced with less choice or higher prices in long run if some suppliers leave the
market

Paul Krugman has been heavily critical of the monopsony power of Amazon in the publishing industry. In 2014
he wrote “Amazon is acting as a monopsony, a dominant buyer with the power to push prices down. By
putting the squeeze on publishers, Amazon is ultimately hurting authors and readers”

Examiner tip

Firms that are monopolies (i.e. dominant sellers) may also be monopsonies (i.e. dominant buyers) – this
allows them to raise prices and reduce costs, leading to very large supernormal profits.

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4.1.5.7 Price discrimination

Key specification content:

• The conditions necessary for price discrimination
• The advantages and disadvantages of price discrimination
• Diagrammatic analysis is expected including the impact on consumers and producers

Price discrimination
Price discrimination is when a business charges different consumers different prices for the same good or
service
Price variations do not fully reflect the marginal cost of supplying a product e.g. higher costs for parcels
delivered over short and long-haul distances in the UK and overseas might be built into the price

There are several types of price discrimination

• 1st degree discrimination
• 2nd degree discrimination
• 3rd degree discrimination

Common error alert!

Price discrimination is not the same as product differentiation where the quality / characteristics of a
good/service vary by the type of customer. Price discrimination moves us away from the assumption in theory
of the firm that there is a single profit-maximising price for the same product. A firm can charge different
prices for one item

Price discrimination in action!

Mobile phone contracts Taxi fares at peak times

Market haggling
/ tariffs of the day

Cinema ticket prices Hairdresser discounts Educational bursaries

Aims of price discrimination

1. To increase total revenue by extracting consumer surplus and turning it into producer surplus
2. To increase total profit providing the marginal profit from selling to customers is positive
3. To generate cash-flow especially during a recession
4. To increase market share and build customer loyalty

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 5. To make more efficient use of a firm’s spare capacity
6. To reduce the amount of waste and cut the cost of keeping products in stock / storage

Quick overview of the different types of price discrimination

• 1st degree
o Charging different prices for each individual unit purchased – i.e. people pay their own
individual willingness to pay
• 2nd degree
o Prices varying by quantity sold e.g. bulk purchase discounts
o Prices varying by time of purchase e.g. peak-time prices
• 3rd degree
o Charging different prices to groups of consumers segmented by price elasticity of demand,
income, age, sex

Conditions required for a firm to use price discrimination

1. Firms have sufficient monopoly (market) power
o Monopolists always have pricing power – i.e. they are price makers not takers
2. Identifying different market segments
o i.e. groups of consumers with different price elasticities of demand
3. Ability to separate different groups
o Requires information / sufficient market intelligence on the purchasing behaviour of
consumers
4. Ability to prevent re-sale (arbitrage)
o No secondary markets where arbitrage can take place at intermediate prices e.g. limiting
sales, age-restrictions, compulsory use of ID cards

First degree price discrimination

First-degree price discrimination is also known as perfect price discrimination or optimal pricing. It refers to
charging each individual customer in the market whatever they are willing and able to pay. This results in all
consumer surplus being ‘extracted’ and converted into producer surplus. Key points:

• First degree price discrimination is hard to achieve unless a business has full information on every
consumer’s individual preferences and their willingness-to-pay. Accessing this information could
cause the business’s (transaction) costs to be very high, which might outweigh the gains of increased
revenued. However, dynamic pricing in online-based markets gives businesses a stronger chance of
achieving this.
o In reality, it is more straightforward and cost-effective for firms (and consumers) to work with
price lists / menus, since this can enable trade / transactions to take place more quickly
without individual negotiations having to take place
• When a firm with monopoly power is able to perfectly segment the market into individual consumers,
its average revenue (AR) curve becomes the same as the marginal revenue (MR) curve.
• The firm will continue to sell additional units so long as the extra revenue exceeds the marginal cost
of production

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 Quick question

What benefits and drawbacks for consumers are there of a firm choosing to perfectly price discriminate?

Third degree price discrimination – analysis diagram

The diagrams below represent a market (such as the cinema) in which tickets for students are cheaper than
those for adults. The diagram on the right-hand side, for the non-segmented market, shows that the price
would be lower for adults but higher for students, if there was no price discrimination. Students arguably have
more price elastic demand – tickets might take up a larger proportion of their income than for adults, and
they may have more substitute activities available.

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Exam Technique: Building a chain of reasoning:
Question: Analyse how consumers may benefit from price discrimination

Price discrimination is One way that some E.g. a bus company may
the charging of different groups of consumers charge students a lower
prices to different may benefit comes from price. Students typically
groups of consumers on third degree have lower income so
the basis of variations in discrimination pricing their demand is more
people’s ability to pay. based on age or income. price elastic.

The consequence can As a result, they can This means that student
be an increase in afford to travel more passengers get a
consumer surplus which regularly within their discounted ticket price
is one measure of budget constraint. It which has the effect of
economic welfare from might make attending increasing their real
market activity. college more affordable. purchasing power.

Evaluating the impact of price discrimination

Possible disadvantages include:
o Higher prices for some consumers, leading to a loss of consumer surplus and a reduction in allocative
efficiency, if P>MC; the consumer surplus is reallocated into producer surplus (i.e. profit)
o Can increase regional inequality if some consumers can only access goods/services at higher prices
o There may be an increase in transaction costs or administration costs for businesses, as they have to
ensure that the market is sub-divided and consumers in each group are kept separate e.g. checking
ID documents for age / status etc. This can possibly reduce profit.
o Groupings of consumers is not perfect e.g. relatively well-off adults taking night-school courses may
have a student card and be able to access student discounts, despite being able to pay the normal
adult price
o Additional profits earned as a result of price discrimination may allow incumbent firms to adopt anti-
competitive practices e.g. predatory pricing, higher entry barriers through more spending on
advertising etc. This can entrench the firm’s dominant market position and cause even higher prices
in the future.

Possible advantages include:

o Lower prices for some groups of consumers, who might not otherwise be able to afford the
good/service in question, therefore widening market access

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 o More profits for the business can result in higher dividends for shareholders and a positive wealth
effect
o More profits can lead to reinvestment / business growth as well as R&D
o Businesses can make better use of spare capacity, increasing demand in quieter times and reducing
overcrowding / excess demand at leak times

General evaluation points include:

o The impact depends on the extent to which price discrimination is used
o The impact depends on how businesses choose to use profits
o It is very difficult in practice to agree on a ‘fair price’ – it is a matter of perspective

Extension – Peak and off-peak pricing

• Uber is a fast-growing taxi service app that operates in more than 50 countries
• Uber uses surge pricing – also known as dynamic pricing
• When market demand exceeds available supply e.g. at peak times, then Uber raises the average fare
on their app
• The aim is to encourage more drivers to take to the roads to expand supply
• The business is taking advantage of low price elasticity of demand at busy times
• Some economists have criticised this policy especially during emergencies such as freak weather
events

Advantgaes

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4.1.5.8 The dynamics of competition and competitive market processes

Key specification content:

• The short run and the long run benefits which are likely to result from competition
• Non-price competition
• Creative destruction

Advantages of competition
• Consumers can benefit from lower prices, leading to an increase in consumer surplus
• Consumers can also potentially benefit from innovation, leading to greater choice and improved
quality, which increases satisfaction and welfare
• Can increase a firm’s customer base, if they offer something very attractive to customers as a result
of competition

Disadvantages of competition
• Some businesses may lose market share – this could cause job loss, and reduced income
• The drive for new products might lead to some products becoming obsolete / unsupported very
quickly, so consumer spending might rise if they need the ‘latest version’ – this can cause
environmental problems too
• The market may become ‘flooded’ due to over-production and so stocks may build up
• Excess choice can lead to the ‘paradox of choice’, and slow down consumer decision-making

The competitive market process and innovation

For all but pure monopoly, where barriers to entry cannot be overcome, the competitive market process gives
firms an incentive to innovate to gain a cost advantage, improve the quality of the service provided or
introduce new products. Even in monopoly, there is an incentive for firms to undertake R&D to innovate and
overcome barriers to entry.

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Innovation
• Innovation is putting a new idea or approach into action
• Innovation is 'the commercially successful exploitation of ideas’
This incentive will be especially large where profits are abnormal. This process
of creative destruction, where new firms challenge and replace existing firms is
a key way in which competition operates in a market economy.

Creative destruction – Joseph Schumpeter

Austrian economist Joseph Schumpeter (pictured) coined the term creative

destruction, which refers to the upheaval of the established order in the pursuit
of innovation.

Product innovation refers to small-scale and frequent subtle changes to the

characteristics and performance of a good or a service

Process innovation can refer to changes to the way in which production takes
place or is organised, or changes in business models and pricing strategies.

Innovation has demand and supply-side effects in individual markets and the economy as a whole

Dynamic efficiency
Creative destruction should lead to improvements in dynamic efficiency. This type of efficiency focuses on
changes in the choice in a market together with the quality/performance of products that we buy. We usually
identify a close link between dynamic efficiency and the pace of innovation in a market. Dynamic efficiency
can cause a firm’s cost curves to shift downwards, and /or demand (revenue) curves to shift to the right.

Examiner tip:

A key way to gain evaluative marks is to consider what is happening to the resources previously employed in
the firms that have been replaced. If they are unemployed for a period of time, then the outcome is far less
favourable.

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4.1.5.9 Contestable and non-contestable markets

Key specification content:

• The significance of contestability for the performance of an industry
• Sunk costs and hit-and-run competition

Characteristics of contestable markets

• Contestable markets exist when there are low barriers to entry and exit, allowing new suppliers to
come into a market and provide fresh competition to established businesses.
• For a perfectly contestable market, entry into and exit out must be costless. This can have implications
for the behaviour (conduct) of existing firms and then affects the performance of a market in terms
of allocative, productive and dynamic efficiency.
• A contestable or competitive environment is common in most industries even when there appears to
be one or more dominant businesses with significant market power

Food retailing Fast Food Hotel / Room City Transport Shaving products
Industry Sharing Sector Services

Bookselling Retail energy Freight / logistics

market
Common error alert!

Contestable markets are characterised by there being the threat of competition – there might only be 1 or
2 firms in the market/industry but they cannot behave as though they have monopoly power, even though
on the face of it there appears to be no competition. There can be any number of firms in a contestable
market!

Conditions required for market contestability:

1. A pool of new businesses who are willing and ready to enter the market
2. No significant entry or exit costs – this lowers the risks of market entry
3. Equal access (for incumbent and potential entrant firms) to available industry technologies
4. High rates of customer switching – i.e. relatively low brand loyalty

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Implications of contestable markets for the behaviour of firms
In general, prices tend to be lower and output higher in contestable markets than in markets with high barriers
to entry/exit.

Price
and Profit maximising
Cost price MC

Price where normal

P1 profits are made

AC

P2

C1 AR

Threat of competition likely to cause Q1 Q2

MR Output
firms to price at P2 rather than P1

If the market is highly contestable which level of price and output is probable?
• If a monopoly decides to operate at the profit-maximising output (i.e. output Q1 in the diagram
above), there is an opportunity for new entrants to engage in “hit and run” competition to undercut
the established dominant firm and perhaps lower market prices and profits.
• Q2 is an output where price = average cost and only normal profits are made. Here there would be
no incentive for firms to enter the market. At Q2, the price is the “limit price”
• The price and output in a contestable market is likely to be somewhere between the profit-maximising
and normal profit equilibria. The more contestable is the market, the higher the likelihood that price
charged will be closer to normal profits only i.e. closer to the limit price

Key exam points:

1. A key point about contestable markets is that the threat of entry affects the day-to-day behaviour of
firms
2. Firms making supernormal profits are vulnerable to “hit and run” competition
3. This means that they are likely to behave more competitively i.e. not earn supernormal profits, in
order to discourage new firms from entering
4. The outcome (in terms of price, output, and profit) in a highly contestable market will resemble perfect
competition, regardless of the number of firms, since incumbents behave as if there were intense
competition
5. Competition policies such as liberalisation of a market that help to open up an industry to new
suppliers or persuade consumers to switch in greater numbers help to increase contestability

Most markets are contestable to some degree, but few come close to being perfectly contestable. The most
important condition for contestability is having low entry barriers and exit costs including low sunk costs. It is
often easier to enter a market when a new rival is already scaled and have access to the latest technology
alongside a brand that consumers recognise and trust and which can be extended into new markets. Amazon
Logistics is a good example of this, so too the use of click and collect services by national supermarket / retail
chains. If sunk costs are high this makes it difficult for new firms to enter and leave the market. Therefore, it
will be less contestable

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Chain of reasoning:
Question: Analyse how firms might be affected by increased contestability

A contestable market In the absence of actual But if a market becomes

exists when there is competition or threat of more contestable – e.g.
freedom of entry and a rival entering a through a policy of
exit into an industry and market, an unregulated liberalization, then
there are limited or no firm could maximise competitive pressures
sunk costs of production profit where MR=MC. will keep prices down

Actual and threatened This is at an output Instead of profit

competition intensifies where price (AR) = maximising, existing
incentives for businesses average cost. Firms are firms would have an
to control their unit making enough profit to incentive to cut prices
costs by avoiding any X- stay in the market perhaps to a level where
inefficiencies. without attracting rivals. normal profit is made.

Types of barrier to entry and exit

Barriers to entry are the means by which firms with market power can successfully prevent the profitable entry
of new suppliers into an industry. Usually the biggest barrier for a new rival is that established businesses have
benefitted from internal economies of scale which means that their average costs are lower. It gives them
scope to lower prices if and when a new firm comes into the market and perhaps avoid making a loss.

Brand (consumer) Control of key Expertise, goodwill

Economies of scale Vertical integration
loyalty technologies and reputation

Strategic entry deterrence refers to ways in which firms with market power can make life difficult for new
entrants:

Examples:
1. Hostile takeovers and acquisitions – i.e. taking a stake in a rival firm or buying it up completely!
2. Product differentiation through brand proliferation (i.e. developing new products and spending on
marketing and advertising to reinforce brand loyalty).
3. Capacity expansions designed to achieve lower unit costs from exploiting internal economies of scale.
4. Predatory pricing: This happens when a dominant company sustains losses in the short run in the
knowledge it can recoup them and raise prices if competition is forced to exit

Sunk costs and the degree of contestability

The key requirement for contestability in a market is the absence of sunk costs:

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 Fire-sales of business Lost business goodwill
assets and unsold stock and customer loyalty

Examples of sunk costs:

1. Asset-write-offs – e.g. writing-off the value of plant and machinery, stocks and the goodwill of a brand
2. Closure or project cancellation costs including redundancy costs, bad debts, contracts with suppliers
and the penalty costs from ending leases for property & equipment
3. The loss of business reputation and goodwill - a decision to leave a market can damage goodwill
among previous customers, not least those who have bought a product which is then withdrawn

Contrasting monopoly with a contestable market

Characteristic / Issue Monopoly Contestable Market

Number of firms Pure monopoly - single firm Any number possible – usually many
Barriers to entry High – entry and exit costs Low – absence of sunk costs makes
market contestable
Supernormal profit High in short and long run Threat of entry limits profits – risk of
hit and run entry
Pricing power Pricing power is important – may Actual and potential competition
be limited by regulation affects pricing
Economic efficiency Low allocative (price >MC) Contestability should help move the
Productive – econ of scale market closer to efficient outcomes
Dynamic – use of profits
Innovative behaviour Potentially strong if profits fund Likely to be strong – e.g. disruptive
research spending technologies

Examiner tip:

Contestable markets are different to other market structures – they are not defined by the number of firms in
the industry. In the exam, look for evidence of barriers to entry; clearly there are entry barriers in all industries,
but judge whether you think they are falling. Use the concept of contestability as a fantastic evaluation tool
e.g. on the surface, a market may look like a monopoly with just one dominant firm, but if entry barriers are
low, then the market could instead be described as contestable.

Key aspects of contestability and regulation

Some markets have become more contestable as a result of there being more regulation on incumbents

• e.g. access for electricity providers / broadband providers to existing networks

o This is because it reduces the sunk costs for new firms who no longer have to provide a large
network before being able to offer a service…we can call this the separation of infrastructure
and service
• e.g. financial markets – large existing banks came under significant fire during / following the financial
crisis, and faced much more regulations (certainly in the UK and EU, although less in the US) and as

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 their operations became more restricted, opportunities arose for ‘challenger banks’ or niche financial
services providers
o Think about “peer to peer lending” such as Funding Circle, or challenger banks such as Metro
Bank. Peer-to-peer lending is not regulated at all, because the firms involved directly connect
borrowers and lenders, rather than taking deposits themselves (thereby meaning that they
do not need to retain a certain amount of capital)
o Supported by innovations such as the Current Account Switch Service, operated by the not-
for-profit firm Pay.UK

Some markets have become more contestable as a result of there being less regulation

• E.g. parcel delivery: EU directives meant that parcel delivery had to be opened up to competition by
2011 (or 2013 for some EU countries), and could no longer be controlled by a government monopoly
i.e. the legal / statutory barrier to entry was removed
o However, removing the legal barrier to entry was only part of the reason for growth in this
area. Delivery firms needed there to be enough deliveries in certain geographical areas to
justify operating a service…helpfully, the rise of internet shopping meant that ever more
households were buying online and needed parcel delivery.
o i.e. removing barriers to entry will only make a market truly more contestable if there is
enough demand to justify the need for new entrants
• Open Skies Agreement in air travel in Europe in the 1990s and the ongoing discussions over Open
Skies between the EU and US
o Led to the rise of low-cost budget airlines (e.g. Easyjet, Ryanair etc), causing incumbents such
as BA to lower their prices and behave more competitively
o However – there remain plenty of barriers to entry in this market so it is not truly contestable!

Examples of regulation / competition policy that can increase contestability:

o Banning cross-subsidisation i.e. an existing company using profits in one part of their firm to
subsidise entry into a new market
o Requiring incumbents to provide ‘network access’
o Removing legal barriers to entry
o Preventing mergers & acquisitions, especially vertical integration that reduces access to
supply chains for new firms (n.b. only 12 have been blocked in the UK between 2004 and
2018!)
o Reducing protectionist measures

ESSENTIAL EVALUATION! There are many other reasons, other than the changing nature of regulation, that
cause markets to become more contestable!

Quick question
Can you think of examples where technology has made markets more contestable?
Can you think of examples where government intervention has made markets more contestable?

4.1.5.10 Market structure, static efficiency, dynamic efficiency and resource

allocation

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 Key specification content:
• The difference between static and dynamic efficiency
• Productive efficiency occurs when average total costs are minimised and allocative efficiency when
P=MC
• Dynamic efficiency is influenced by R&D, investment and technological change
• Efficiency concepts may be used when comparing the performance of firms in different market
structures

What is economic efficiency?

• Efficiency is about a society making optimal use of scarce resources to help satisfy changing wants &
needs
• There are several meanings of efficiency, but they all basically link to how well a market system
allocates our scarce resources to satisfy consumers
• Normally the market mechanism is good at allocating inputs, but there are occasions when markets
can fail

Static efficiency
This refers to how well scarce resources are being used at a point in time. The key measures are allocative
and productive efficiency.

Allocative efficiency
• Allocative efficiency occurs when the value that consumers place on a good or service (reflected in
the price they are willing and able to pay) equals the cost of the factor resources used up in
production.
• The main condition required for allocative efficiency in a market is that market price = marginal cost
of supply
• This can also be expressed as AR = MC

Productive efficiency
• A firm is productively efficient when it is operating at the lowest point on its average cost curve i.e.
unit costs have been minimised (lowest AC occurs when AC = MC)
• Productive efficiency exists when producers minimize the wastage of resources
• Productive efficiency relates to when an economy is on their production possibility frontier
• An economy is productively efficient if it can produce more of one good only by producing less of
another.

Dynamic efficiency
• Dynamic efficiency occurs when businesses supplying a market successfully meets our changing
needs and wants over time. Crucial to dynamic efficiency is whether the market generates rapid
innovation both in the processes of supply and the range of products available
• Most people associate dynamic efficiency with innovation:

Innovation is putting a new idea into action. Innovation is 'the commercially successful exploitation of ideas'
• Product innovation
o Small-scale and subtle changes to the characteristics and performance of a good or a service
• Process innovation
o Changes to the way in which production takes place or is organised
o Changes in business models and pricing strategies

Innovation occurs as the result of research and development bringing about technological change. Investment
may be required to implement these innovations.

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Key Summary of Economic Efficiency Concepts

Pareto efficiency and X-inefficiency are not part of the syllabus but are useful nonetheless.

Allocative efficiency Producing what is demanded by consumers at a price that reflect the marginal
cost of supply

AR = MC
Dynamic efficiency Changes in the choices available in a market together with the
quality/performance of products that we buy. Linked closely to the rate of
innovation/invention

This can often cause the firm’s AC cure to shift downwards.

It can be caused by a firm earning significant supernormal profit which it then

reinvests into the business.
Pareto optimality Where it is not possible for households, or firms to bargain or trade in such a
way that everyone is at least as well off as they were before and at least one
person is better off

This exists if there is both allocative efficiency and productive efficiency

Productive efficiency Producing an output at the lowest feasible average cost. This is at an output
where AC=MC in the short run, or at the minimum efficient scale in the long
run
X-inefficiency A lack of real competition may give a monopolist a weak incentive to invest in
new ideas or consider consumer welfare. Average costs drift higher as a result.

Allocative and productive efficiency in an analysis diagram

Price
and
Cost MC
Q1 – Productive efficiency
where AC=MC

AC Q2 – Allocative efficiency
MR where AR=MC

AR

Q1 Q2 Output

Quick question

Using the previous diagram, for each of the productive and allocatively efficient levels of output, can you
work out:
- The price

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 - The level of profit?

Do go back and review the material on efficiency in different market structures in section 4.1.5.1

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4.1.5.11 Consumer and producer surplus

Key specification content:

• Application (and diagrammatic analysis) of producer and consumer surplus is expected when
discussing economic efficiency and welfare issues

Consumer surplus
Consumer surplus is a measure of the welfare that people gain from consuming goods and services. Consumer
surplus is the difference between the maximum that consumers are willing and able to pay for a good or
service and the total amount that they actually do pay. On a demand and supply diagram, it is represented
by the area underneath the demand curve and above the market price. Consumer surplus rises or falls as the
market price for a good or service changes

Simple example of consumer surplus

The table shows the maximum price a consumer would be willing to pay for successive cans of a sports drink.
Assume that the market price is £1 per bottle and that the consumer will only consume an extra can if the price
is less than or equal to their “willingness to pay”.

Cans 1st 2nd 3rd 4th 5th

Price (£) £2 £1.80 £1.50 £1.10 80p
Consumer £1 £0.80 £0.50 £0.10 Not consumed
surplus

Total consumer surplus if this person buys 4 cans will be £2.40 from a total spending of £4.

Consumer surplus and price elasticity of demand

• When demand for a good or service is perfectly elastic, consumer surplus is zero because the price
that people pay matches what they are willing to pay.
• In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Quantity demanded does
not respond to a price change. Whatever the price, the quantity demanded remains the same.
• The majority of demand curves are downward sloping. When demand is price inelastic, there is a
greater potential consumer surplus because there are some buyers willing to pay a high price to
consume the product.

Examiner tip

You might choose to illustrate consumer surplus on a demand and supply diagram, or show how it has
changed following a change in demand and/or supply. Because you can only use black ink on your exam
paper, you need to practice either a) using “hatching” to indicate different areas on a diagram or b) labelling
the corners of shapes you want to describe e.g. “Triangle ABC represents the initial consumer surplus”.

If you need to calculate consumer surplus, either as in the table shown above, or by calculating the area of a
triangle shown on a demand and supply diagram, remember that the formula for calculating a triangle’s area
is (base x height / 2)

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Price discrimination and consumer surplus
You met price discrimination in section 4.1.5.7. Producers often take advantage of consumer surplus when
setting prices. For example, if a business can identify groups of consumers within their market who are willing
and able to pay different prices for the same products, then the business can use price discrimination – this is
a way of turning consumer surplus into producer surplus.

• Airlines and train companies are expert at this, extracting from consumers the price they are willing
and able to pay for flying to different destinations are various times of the day, and exploiting
variations in elasticity of demand for different types of passenger service.
• You will always get a better deal with airlines such as EasyJet and Ryan Air if you are prepared to book
in advance. The airlines are happy to sell tickets more cheaply because they get the benefit of cash
flow together with the guarantee of a seat being filled. The nearer the time to take-off, the higher the
price
• If someone is desperate to fly from Newcastle to Paris in 24 hours’ time, his or her demand is said to
be price inelastic and the corresponding price for the ticket will be much higher.
Changes in supply and demand, market price and consumer surplus
Consumer surplus rises or falls as the market price for a good or service changes – here are two examples:

Price Higher4supply4costs4leads4to4a4 Price An4increase4in4market4demand4

rise4in4market4price4and4 causes4consumer4surplus4to4
B therefore4a4fall4in4consumer4 rise4from4area4ABC4to4area4GHI
surplus4from4ABC4to4DBE H

S2
B I S1
D E G

S1 A C D2
A C

Demand
Demand

Q2 Q1 Quantity Q1 Q2 Quantity

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Producer Surplus
Producer surplus is the difference between the price producers are willing and able to supply a product for
and the price they get in the market. Producer surplus is shown by the area above the supply curve and below
the price. Higher prices provide an incentive to for businesses to expand supply. This is due to the profit
motive.

Changes in demand and supply, market price and producer surplus

Lower2supply2costs2cause2price2 An2increase2in2market2demand2
Price to2fall2and2equilibrium2quantity2 Price leads2to2a2higher2price2&2
to2rise.2Producer2surplus2 quantity2leading2a2rise2in2
increases2from2area2ADB2to2 producer2surplus2from2area2
area2FEC2 ABC2to2DEC

S1 S1
D E
A D
E B
S2 A D2
F

B C
D1
D1
C

Q1 Q2 Quantity Q1 Q2 Quantity

Another term for producer surplus is “supernormal profit”.

Quick question:

You can now illustrate total revenue and producer surplus (“profit”) on a demand and supply diagram. One
‘triangle’ of the total revenue area is producer surplus – can you explain why the remaining ‘triangle’ in that
total revenue rectangle must represent total costs?

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Extension idea: community surplus
Community surplus is the sum of consumer and producer surplus. In the diagram below, at the equilibrium
price and output, consumer surplus is shown by triangle RSP and producer surplus by triangle QRS. Most
competition policy is designed to protect consumers from exploitation by producers. But it is simply a ‘value
judgement’ to say that consumer surplus is ‘more important’ than producer surplus.

Price
Consumer6and6producer6
R
surplus6are6important6
concepts6to6use6when6
Supply discussing6the6effects6of6
Consumer6 different6government6
surplus S interventions6in6markets6such6
P as6taxes6&6subsidies6

Producer6
surplus Demand Changes6in6conditions6of6
market6supply6and6demand6
will6bring6about6changes6in6
the6level6of6consumer6and6
Q producer6surplus6(economic6
welfare)

O
T Quantity

Market changes and consumer / producer surplus

The table below summarises some of the effects on consumer and producer surplus from changes in the
conditions of market demand and supply and/or intervention by the government.

Market change Consumer surplus Producer surplus

Outward shift of demand Increase Increase
Government subsidy to producers Increase Increase
Cost-reducing innovation Increase Increase
Minimum price for consumers Fall Uncertain
Indirect tax on producers Fall Fall
Inward shift of market demand Fall Fall
Maximum price for consumers Uncertain Fall

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4.1.6.1 The demand for labour: marginal productivity theory

Key specification content:

• The demand for a factor is derived from the demand for the product
• The marginal productivity theory of the demand for labour
• The demand curve for labour shows the relationship between the wage rate and the number of
workers employed
• The causes of shifts in the demand curve for labour
• The determinants of the elasticity of the demand for labour

Factors that influence the demand for labour

• The demand for labour shows how many workers an employer/business is willing and able to hire at
a given wage rate in a given time period.
• There is normally an inverse relationship between demand for labour & the wage rate.
• If the wage rate is high, then it becomes costly for a business to hire extra employees.
• When wages are lower, labour becomes relatively cheaper than capital. A fall in the wage rate might
therefore create a substitution effect and lead to an expansion in labour demand.

Common error alert!

Some students can get confused with the labour market because the economic agents are effectively the
opposite way around compared to product markets i.e. it is firms that are demanding labour, and households
are supplying their labour.

Wage Higher wages – Wage

Rate contraction of Rate
demand
W2
Lower wages
– expansion
W1 of demand
W1
W3

Labour
Demand

LD3 LD1 LD2

E3 E1 E2
Employment E2 E1 E3 Employment

Marginal productivity theory

The demand curve for labour is derived from the marginal revenue product of labour. This in turn comes
from the marginal physical product which is closely related to the law of diminishing returns.

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Marginal Revenue Product of Labour
• The demand curve for labour tells us how many workers a business will employ at a given wage rate
in a given time period
• In the theory of competitive labour markets, the demand curve for labour comes from the estimated
marginal revenue product of labour (MRPL)
• Marginal revenue product of labour (MRPL) is the extra revenue generated when an additional worker
is employed
• Formula: MRPL = marginal product of labour x marginal revenue

Marginal Revenue Product Calculation

• We are assuming here that the firm employing labour is operating in a perfectly competitive market
so that each unit of output sold generates revenue of $20.
• Firms are assumed to be profit maximisers and they will choose a level of employment that maximises
profit. The MRPL curve is the demand curve for labour. MRPL falls when diminishing returns set in.

Units of labour Total output of Marginal Price of output Marginal

employed labour per product (assume revenue
week MR=AR) product of
labour (MRPL)
1 10 10 $20 $200
2 24 14 $20 $280
3 44 20 $20 $400
4 60 16 $20 $320
5 72 12 $20 $240
6 80 8 $20 $160
7 84 4 $20 $80

• Let us assume that each worker employed costs the firm $160 per day – this is the marginal cost of
labour
• At this wage rate of $160 the firm should employ 6 workers
• A profit maximising firm should employ workers up to the point where the marginal revenue product
of labour = the marginal cost of labour. In this case, when 6 people are employed MRPL and MCL
both equal $160. Employing the 7th worker would lead to a fall in total profits

Note: This theory assumes competitive labour markets and also competitive product markets i.e. where the
final price of output is the same so that AR=MR.

Evaluating marginal revenue product

• MRPL is the change in revenue from the output produced by the extra worker employed
• In the theory of the labour market, MRPL is taken as the basis for the labour demand curve
• Problems:
1. Measuring labour efficiency / productivity can be difficult
2. Relatively easy to measure productivity in the construction industry and in call-centres
3. Much harder to measure productivity in consultancy, education
4. Collaborative work makes it difficult to establish the productivity of individual workers
5. Many products are the result of inputs drawn from different countries – each contributing to
value added (e.g. the iPhone)
6. Many people have the ability to set their own pay e.g. the self-employed and directors of
businesses

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Derived Demand for Labour
• Derived demand is the demand for a factor of production used to produce another good or service
o Steel: The demand for steel is strongly linked to the market demand for cars and the
construction of new buildings.
o Labour: In factor markets, the demand for labour is derived from the demand for the output
of goods and services
• When the economy is growing strongly, many businesses will be looking to hire extra workers to
supply increased output
• During a recession or a prolonged economic slowdown, the demand for labour tends to fall causing
a rise in cyclical unemployment.

Wage Elasticity of Labour Demand

Elasticity of labour demand measures the responsiveness of demand when there is a change in the wage rate.
It depends on:
1. Labour costs as a % of total costs: When labour expenses are a high % of total costs, then labour
demand is more wage elastic.
2. Ease and cost of factor substitution: Labour demand is more elastic when a firm can substitute easily
and cheaply between labour & capital inputs.
3. Price elasticity of demand for the final product: This determines whether a firm can pass on higher
labour costs to consumers in higher prices. If demand is inelastic, higher costs can be passed on.
4. Time period – in the long run it is easier for firms to switch factor inputs e.g. bring more capital in
perhaps replacing labour

LD1%is%elastic%– i.e.%employment%is% LD2%is%inelastic%– i.e.%a%large%rise%in%wages%

sensitive%to%a%changing%wages causes%only%a%small%fall%in%employment

Wage% Wage%
Rate Rate
W3 W3

W2
W1 W1

LD1

LD2

E2 E1 Employment E3 E1 Employment
Shifts in the Labour Demand curve
The labour demand curve shifts when there is a change in:
1. A rise in final consumer demand which means that a business needs to take on more workers
2. A change in the market price of the output that labour is making
3. An increase in the productivity of labour which makes labour more cost efficient than capital (higher
productivity increases the marginal product of labour)
4. A government employment subsidy which allows a business to employ more workers

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 5. A change in the cost of capital equipment (a possible substitute for labour) e.g. robotic technologies

Shifts in the labour demand curve illustrated

Wage%
Rate

W1

LD3 LD1 LD2

E3 E1 E2
Shifts%in%labour%demand% Employment
are%caused%by%factors%other%
than%the%wage%rate

Derived Demand for Labour

• Derived demand is the demand for a factor of production used to produce another good or service.
• When the economy is growing strongly, many businesses will be looking to hire extra workers to
supply increased output.
• During a recession or a prolonged economic slowdown, demand for labour tends to fall causing a
rise in cyclical unemployment.

The construction industry is a good example of a sector where employment is cyclical. When demand for new
buildings is growing quickly, there will be an expansion of demand for many different types of jobs within the
industry. However, in a cyclical downturn, construction employment is likely to fall.

Forecasted number of people employed in the construction industry in the United Kingdom (UK) in 2022, by
occupation

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 Number of people employed
0 100000 200000 300000 400000

Non-construction professional, technical, IT and other… 399,960

Wood trades and interior fit-out 256,730
Other construction process managers 223,170
Other construction professionals and technical staff 219,130
Senior, executive, and business process managers 188,400
Electrical trades and installation 182,800
Plumbing and HVAC Trades 161,520
Labourers nec* 138,090
Painters and decorators 109,940
Building envelope specialists 103,290
Surveyors 78,790
Bricklayers 70,460
Civil engineers 61,290
Specialist building operatives nec* 55,290
Construction trades supervisors 54,460

Automation and the demand for labour in different jobs

The chart below shows the share of jobs at potential high risk of automation in the UK until 2030, by industry.
(Source: PWC, 2018)

Share of overall jobs

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0%

Manufacturing 45%
Wholesale and retail trade 42%
Construction 23%
Human heath and social work 18%
Education 8%

Automation, robotics and the extension application of artificial intelligence / machine learning will create
significant changes in the pattern of employment. Routine, less well-paid work, has been and remains most
susceptible to automation. In the USA, according to a 2013 paper by two Oxford academics, 47% percent of
jobs are at “high risk” of being automated within the next 20 years – 54% of lost jobs will be in finance.
Technology also has the potential to create more and better jobs. Some of them come in the new sectors,
such as app designers and software engineers.

Examiner tip

Wage elasticity of labour demand (or supply) is a really useful concept to introduce into your answers
because it can allow you to make more evaluative comments and indicate that you have really thought
about the context you have been given.

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4.1.6.2 Influences upon the supply of labour to different markets

Key specification content:

• The supply of labour to particular occupations is influenced by monetary and non-monetray
considerations
• Non-monetary considerations include job satisfaction and working conditions
• The supply curve for labour shows the relationship between the wage rate and the number of
workers willing to work in an occupation
• The causes of shifts in the market supply curve for labour
• Knowledge of the backward bending supply curve is NOT required

Factors that influence the supply of labour to a particular occupation

Labour supply to industry / occupation

The labour supply is the number of hours that people are willing and able to work at a given wage rate

Labour supply: Hours that people are willing and able to supply at a given wage rate.

• The labour supply curve for Wage

Rate Labour
any industry or occupation will supply
be upward sloping.
W2
• As wages rise, other workers
enter this industry attracted
by the incentive of higher pay W1

• The extent to which a rise in

the prevailing wage or salary
W0 W0 – reflects the lowest
in an occupation leads to an pay rate at which people
expansion in the supply of are willing to work in an
labour depends on the occupation – this is called
the reservation wage
elasticity of labour supply
E1 E2 Employment

Factors causing shifts in the supply of labour to an occupation / industry

1. Real wage rate on offer in the industry itself plus extra pay – e.g. overtime, productivity pay, share
options
2. Wages on offer in substitute occupations: e.g. increase in the earnings for plumbers and electricians
may cause people to switch their jobs
3. Barriers to entry: Artificial limits to an industry’s labour supply (e.g. minimum qualifications might be
needed) can restrict supply and increase average wages compared to other jobs
4. Improvements in the occupational mobility of labour and stock of human capital e.g. as result of
expansion of apprenticeships and other types of work experience – increases numbers who can work
in a given job
5. Non-monetary characteristics of specific jobs – e.g. job risk, need to work anti-social hours, job
security, working conditions, career progression, the chance to live & work overseas, quality of in-
work training, occupational pension schemes.
6. Net migration of labour – e.g. net inward migration expands the active / available labour supply in
many occupations such as people working in the National Health Service, construction and farming
7. Demographic factors affecting the overall size of the working population
8. People’s preferences between work/leisure and desire for work flexibility

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 Quick question
What factors might affect supply of labour to the following occupations?
- Supermarket workers
- Accountants
- Artists?

Non-wage factors affecting labour supply

Job risk and job Career opportunities Anti-social hours Generosity of

security occupational
pensions

Strength of vocation Working conditions – Quality of in-work Living and working

terms of contract training / overseas
professional
development
Labour supply to an occupation is affected by factors other than wages. For example:
• Working conditions
• Amount of leisure time
• Facilities available at work
• Ability to work flexible hours at different times
• Opportunities for career progression / travel
• Extent of autonomy given to people in their job

Elasticity of labour supply

Elasticity of labour supply describes the responsiveness of the quantity of labour supplied in response to a
wage change.

Wage Wage
Rate In relatively lower-skilled jobs, the Rate
labour supply is elastic because a LS2
pool of labour is available to be W2
employed at a fairly constant market
wage rate.

W1

LS1
W2
Where jobs require specific skills and
W1 training, the labour supply will be
more inelastic.

E1 E2 Employment E1 E2 Employment

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Factors affecting elasticity of supply of labour to an occupation / industry:
• Nature of skills and qualifications required to work in an industry
o Specific skills and educational requirements make supply inelastic
o Lengthy and costly training periods makes labour supply inelastic
o When the minimum skill factor needed is relatively low, then the pool of available labour will
be large, making labour supply elastic
• Vocational nature of work - in jobs such as nursing, people are less sensitive to changes in wages
when deciding whether to work and how many hours to work
• Time period –
o In the short run, the supply curve for labour to a job tends to be inelastic
o It takes time for people to respond to changes in relative wages and earnings – especially if
people need to be re-trained
o When labour is geographically and occupationally mobile, then labour supply will tend to be
relatively elastic even in the short term

Extension material - market failure in labour markets: the geographical and occupational mobility of labour

There are many root causes of labour market failure and these have consequences not only for individuals
and households concerned but also due to the wider impact on business performance and macro
competitiveness.

Geographical Occupational Employer Monopsony Disincentives to Training Gaps

immobility immobility discrimination employers work

Geographical immobility of labour

Geographical immobility refers to barriers people moving from one area to another to find work.

High cost of
Family ties Migration controls Language barriers
property

Reasons why geographical immobility exists and persists:

1. Family and social ties – older people more reluctant to move
2. Financial costs involved in moving home including the costs of selling a house and removal expenses.
3. Regional / local variations in house prices leading to a shortage of affordable housing in many areas
4. High cost of renting a suitable property
5. Differences in the cost of living between regions and countries and variations in tax and pension
systems
6. Migration controls e.g. possible caps on inward migration
7. Cultural and language barriers to living and working overseas
8. A default behavioural instinct which is a dislike of change including your place of employment
9. High transport costs, or very slow travel, between one region and another, preventing people from
living in one place and commuting elsewhere

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Key data: Renting in the UK:
There are an estimated 4.5 million households renting privately which is around 20% of all households in the
UK. Well over 2 million households rent within Greater London. Significantly, the proportion of households
with children living in the private rented sector has increased. In 2018, the median rent for a two-bed property
in London was around 50 percent of the monthly salary of a London resident working full-time. In England as
a whole, the proportion was 26%.

Occupational immobility of labour

Occupational immobility occurs when there are barriers to the mobility of factors of production between
different sectors of the economy leading to these factors remaining unemployed or being used in ways that
are not efficient.

Skills gaps Experience gaps Education gaps Low confidence

Key causes of occupational immobility include:

1. Skills gaps: New jobs may require different skills from those that unemployed workers can offer.
2. Training gaps: Unemployed workers may not have access to affordable training schemes that would
allow them to improve their human capital and improve employability
3. Experience gaps: The long term structurally unemployed often have gaps in their CVs that make less
them attractive to employers
4. Confidence and motivation: The longer someone is unemployed, the harder it is to find fresh work.
Skills decline and so too does confidence and motivation to look for a job
5. Discrimination: this can be in terms of age, gender, sexual orientation, race/ethnicity etc. Whilst
discrimination is illegal in the UK, it may still be an important cause of occupational immobility.

Skills lacking among staff with skills gaps in the United Kingdom in 2017

Proportion of all staff with skills gaps

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0%

Technical, practical or job-specific 65%

Problem solving 41%
Customer handling 39%
Team working 37%
Numeracy 30%
Written communication 28%
Planning and organisation 26%
Basic computer literacy / using IT 23%
Advanced IT or software 21%
Strategic Management 21%
Literacy 18%
Oral communication 17%
Foreign language 16%

Focus on Labour Market Failure from Immobility

• It is a cause of structural unemployment and economic vulnerability

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 o Occupational immobility is a barrier to people finding work
o Towns with low mobility more exposed to external economic shocks
• It is a cause of persistent relative poverty
o Long-term unemployment damages lifetime earnings
o Areas with low mobility more likely to supper economic deprivation leading to a fall in
incomes / higher debt levels
• Loss of economic efficiency and social welfare
o Immobility stops scarce resources from being used optimally – leading to a loss of potential
output
o Social costs from increased unemployment and from rising level of relative poverty

Extension idea: disincentives in the labour market

Poverty Trap Unemployment Trap

The Poverty Trap

• The poverty trap affects people on low incomes. It creates a disincentive to look for work or work
longer hours because of the effects of the tax and benefits system
• Working more hours means some benefits are cut
• Earning extra income also means that people now pay national insurance and income taxes
• The overall marginal rate of tax (including benefit withdrawal) may be high – perhaps close to 100%

The Unemployment Trap

• When the prospect of the loss of unemployment benefits dissuades those without work from taking
a new job – this creates a disincentives problem in the labour market

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4.1.6.3 The determination of relative wage rates and levels of employment in
perfectly competitive labour markets

Key specification content:

• The model of wage determination in a perfectly competitive labour market
• The role of market forces in determining relative wage rates
• All real-world markets are imperfectly competitive to a greater or lesser extent.

Assumptions of a perfectly competitive labour market

These are similar to the assumptions in a perfectly competitive product market:
• There are many workers and firms all of whom are homogenous
• No worker or firm can influence the prevailing wage rate
• There are no barriers to entry
• Information is perfect.
• Firms can employ as much labour as they like at the prevailing wage rate

At the industry level, market forces determine the equilibrium wage rate. As shown, the wage rate is W. In
perfect competition, firms are wage takers and the assumption that they can employ as much labour as they
like at the prevailing wage means that they face a perfectly elastic supply curve S. Profit maximising employers
will employ labour to the point where MC = MRP. This is EF in the example shown.

Clearly, the assumptions underpinning the perfectly competitive labour market model are unrealistic – and
so therefore all labour markets are, to some extent, imperfect.

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4.1.6.4 The determination of relative wage rates and levels of employment in
imperfectly competitive labour markets

Key specification content:

• How various factors such as monopsony power, trade unions and imperfect information contribute
to labour market imperfections
• In a monopsony, an employer can reduce both the wage and the level of employment compared
with perfect competition

What is a monopsony employer?

• A monopsony occurs when there is a sole or a dominant employer in a labour market
• This means that the employer has buying power over their potential employees
• This gives them wage-setting power
• Monopsony is a potential cause of labour market failure
• For a monopsony, the supply curve of labour equals the average cost of labour
• The monopsony employer will have to bid up wages in order to attract new workers
• But the wage they pay will not necessarily reflect the true marginal revenue product of people
employed

Examples of Monopsony Employers

National Health Service Armed Forces Big Out-Sourcing Businesses

Amazon Supermarkets Local councils

Wage determination in a monopsonistic labour market

• The labour supply curve is the average cost of employing people i.e. wage per person employed
• The marginal cost of labour is the change in total costs from employing one extra worker
• Profit maximising employment level is where MCL=MRPL i.e. E2 number of people are employed
• Their marginal revenue product is valued at W2
• But monopsony power of the employer allows them to pay wage rate W3

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 Wages%lost%from%
Wage% underFpayment%by% Marginal%cost%
Rate employer of%labour% (MCL)

W2 Labour%Supply%
(=%ACL)
W1
W3

Total%
wages% Labour%Demand%
=%MRPL

E2 E1 Employment

Compared with the perfectly competitive market outcome of E1, W1, both wages and employment are lower.

Imperfect information

Imperfect information could lead to a number of labour market imperfections. Information failure on the part
of an employer regarding marginal revenue product might lead them to adopt heuristics, or simple rules of
thumb which could be associated with discrimination (discussed below). Labour may be unaware of their own
MRP, again making discrimination possible. Information failures of the requirements for particular occupations
or the employment opportunities available, might limit labour market flexibility.

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4.1.6.5 The influence of trade unions in determining wages and levels of
employment

Key specification content:

• Various factors that affect the ability of trade unions to influence wages and employment in
different labour markets
• The use of diagrams is expected

Trade Unions in the Labour Market

• Trade unions use collective bargaining with employers to protect their members
• Most unions belong to the Trades Union Congress (TUC)
• The percentage of employees who are members of a union in the UK fell from 32% in 1995 to 23%
in 2018
• In 2018, just over 6 million people were registered as members of a trade union

Trade Union membership in 2018 – largest unions

0 400000 800000 1200000 1600000

Unite the Union 1,397,803

UNISON: The Public Service Union 1,282,671
GMB 617,213
Royal College of Nursing of the United Kingdom 452,669
Union of Shop Distributive and Allied Workers 434,790
National Union of Teachers 372,937
National Association of Schoolmasters Union of Women Teachers 318,700
Association of Teachers and Lecturers 192,646
Communication Workers Union 190,628
Public and Commercial Services Union 185,785
British Medical Association 161,708
Prospect 112,576
University and College Union 103,985

Trade union density

Percentage of employees that were members of a trade union in the UK from 1995 to 2017
34.0%

32.0%
Percentage of employees

30.0%

28.0%

26.0%

24.0%

22.0%

20.0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

There has been a long-term decline in union membership. Membership is ageing and is focused in public
sector occupations. Factors behind trade union decline include:

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 1. Impact of legislation that has reduced/removed many of their powers to engage in industrial action
2. Rise in flexible labour markets e.g. with short term contracts, zero hours, part time working, self-
employment
3. De-industrialisation – there are fewer jobs in industries where unions tended to be stronger – e.g. less
jobs in heavy manufacturing and many more in services
4. Impact of globalisation which has reduced the bargaining power of employees

Collective
Employee rights Pension entitlement Protecting jobs
bargaining

Health & safety Workplace training

Key roles for trade unions

• Protecting and improving the real living standards / real wages of their members
• Protecting workers against unfair dismissal (i.e. upholding employment rights)
• Promoting improvements in working conditions, work-life balance & related health and safety issues
• Promoting better workplace training and education, i.e. the accumulation of human capital
• Protection of pension rights for union members

Trade unions, wages and employment – using standard labour market analysis
• Trade Unions may bid for employers to pay a premium wage above the normal competitive market
wage.
• This might lead to an excess supply of labour and a contraction of total employment
• Unions will have more success in raising wages for members if demand for labour is relatively wage
inelastic
• Unions also more influential when they represent a high % of all workers in a given
industry/occupation
• Pay might also rise if unions and employers agree a pay deal based on better productivity

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The impact of a trade union in a perfectly competitive labour market

Wage% • Trade%Unions%may%bid%
Rate
for%employers%to%pay%a%
Labour%Supply premium%wage%(or%
“wage%mark?up”)%
W2 above%the%normal%
Union%negotiated%
competitive%market%
W1 wage wage
• This%might%lead%to%an%
excess%supply%of%labour%
and%a%contraction%of%
total%employment

Labour%Demand

E2 E1 Employment

Higher%wage%income%from%
Wage% • Trade%Unions%may%bid%
union%collective%bargaining
Rate
for%employers%to%pay%a%
Labour%Supply premium%wage%(or%
“wage%mark?up”)%
W2 above%the%normal%
Union%negotiated%
competitive%market%
W1 wage wage
• This%might%lead%to%an%
excess%supply%of%labour%
and%a%contraction%of%
total%employment

Labour%Demand

E2 E1 Employment

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Impact on total income to workers employed

Higher%wage%income%from%
Wage% • Whether%or%nor%higher%
union%collective%bargaining
Rate
Lost%wage%income% wages%achieved%by%
from%contraction% Labour%Supply unions%from%collective%
in%employment bargaining%lead%
W2 increased%total%income%
Union%negotiated%
depends%on%what%
W1 wage happens%to%the%
employment%of%people%
in%this%particular%labour%
market.

Labour%Demand

E2 E1 Employment

• Unions will have more success in raising wages for their members if the demand for labour is relatively
wage inelastic
• Unions also more influential when they represent a high % of all workers in a given
industry/occupation
• Pay might also rise if unions and employers agree a pay deal based on success in lifting productivity

If a trade union is successful in introducing productivity improvements a better outcome may be achieved. In
this case, MRP increases, shifting the demand curve, possibly to the point where a new equilibrium is achieved
at the trade union wage rate

Wage Wage
rate rate
Labour supply Labour supply
W2
W2

W1 W1

LD2 (higher
productivity)

Labour demand (MRPL) Labour demand (MRPL)

E2 E1 Employment of labour E1 E2 Employment of labour

The impact of a trade union in a monopsonistic labour market

If instead (as is more likely), a trade union is introduced into a monopsony labour market, then the outcome
is rather different. If wage W2 is the trade union wage, the profit maximising level of employment is now L2.
Both wages and employment have increased.

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 Examiner tip

In considering the impact of introducing a trade union, it is critical to consider the conduct of the trade
union and the comparator – are you comparing with monopsony or perfect competition?

Trade unions and the labour market – some key evaluation points
• Long term decline in union membership – which reflects the growing flexibility of the UK labour
market including zero-hour contracts + decline of heavy industry and shrinking public sector
• Trade union influence on pay depends in part on trade union density in an industry and also the
credible threat power they have with possible industrial action (e.g. London Tube drivers)
• New Unionism focuses less on wage bargaining and more on protecting employment, pension rights,
health and safety, workplace training, addressing gender & other discrimination
• Don’t assume that trade unions successfully negotiating higher wages will inevitably lead to a
contraction in employment / jobs (this is lazy economics!) – challenge theoretical assumptions!
• Trade Unions may negotiate a combined pay and productivity deal with employers – a positive-sum
game! Use some game theory!

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4.1.6.6 The national minimum wage

Key specification content:

• The effect of a national minimum wage upon labour markets
• The advantages and disadvantages of a NMW

Economics of the Minimum Wage

A minimum wage is a legally-enforced pay floor in the labour market. The National Minimum Wage (NMW)
applies to most workers and sets minimum hourly rates of pay, which are updated annually. The National
Living Wage (NLW) was introduced in 2016 and is the new name for the NMW rate that applies to workers
aged 25 and over. The minimum wage is an important government intervention which as an impact on the
demand and supply-side of the labour market together with broader macroeconomic effects. The minimum
wage targets rates of pay for the poorest-paid workers and the chart below tracks the median full-time weekly
pay of the lowest-earning occupations in the UK.

Median full time gross weekly pay of the lowest paid occupations in the UK (April 2016)

Median full time gross weekly pay in GBP

0 50 100 150 200 250 300 350

Bar staff 281.2

Waiters and waitresses 282.1
Leisure and theme park attendants 284.2
Hairdressers and barbers 285.7
School midday and crossing patrol occupations 286.4
Launderers, dry cleaners and pressers 290.2
Retail cashiers and check-out operators 297
Florists 298.9
Kitchen and catering assistants 302
Fishmongers and poultry dressers 302.9

Analysis of a minimum wage

The free market equilibrium wage is W1 with employment level of E1. If a minimum wage of W2 is introduced
– other factors remaining the same – employment contracts to E2 and the supply of labour expands to E3.

Wage% Wage%
Rate Rate LS1
LS1

W2 Min%Wage

W1
W1

LD1
LD1

E1 Employment E2 E3 Employment

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A standard minimum wage diagram suggests that a pay floor will lead to a contraction of employment. But
this depends on the level at which the minimum wage is set. If labour demand is inelastic, a higher minimum
wage will cause only a limited contraction on the level of labour demand.

Wage% Wage%
Rate Labour%Rate Labour%
Supply Supply

MW MW
W1
W1

Labour% Labour%
Demand Demand

E2 E1 E3 Empl E2 E1 E3 Empl

Common error alert!

Take care to show the minimum wage being set above the free market equilibrium.

National living wage compared to national minimum wage (21 years and over) in the UK from 2011 to 2017
Living wage Minimum wage

10
8.75
9 8.25 8.45
7.65 7.85
8 7.45 7.5
7.2 6.95
6.5 6.7
7 6.31
Wage per hour in £s

6.08 6.19
6
5
4
3
2
1
0
2011 2012 2013 2014 2015 2016 2017

Evaluating the minimum wage

Case for a higher minimum wage Arguments against a rise in the minimum wage

• Equity justification: Every job should give fair • Jobs: Higher minimum wage adds to the costs
pay linked with skills/experience of an of employing workers and might cause higher
employee. unemployment
• Poverty reduction: A minimum wage boosts the • Small businesses: Many smaller businesses
take-home pay of thousands of lower paid struggle to make a profit - risk of a rise in
workers business closures
• Training: It encourages firms to up-skill their • Training: There are better incentives for training
workers and can lead to higher labour than a minimum wage e.g. tax relief on
productivity apprenticeships

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 • Incentives: Will improve incentives for people to • Competitiveness: Might make many UK
look for paid work rather than stay on benefits businesses less competitive in some global
markets
• Anti-discrimination: A way of tackling • Inflation: Higher labour costs might cause
discrimination of low-paid female / younger higher inflation which lowers real incomes for
workers households

Extension idea - Maximum Wages / Salary Caps

The level of executive pay has become a major issue in the UK and many other countries. The Labour Party is
proposing introducing a legal cap on the ratio of executive pay to the median pay of a company’s workers.

Arguments for executive pay ceilings

• Equity and fairness:
o Ratio of pay of executives to ordinary workers has grown to unacceptable levels
o Damages social cohesion when the super-rich see their pay and earnings soar
o Shareholders are reluctant to impose controls on pay at the AGM, many are passive investors
• Bonus culture encourages short-term decision-taking rather than focusing on the long-term strategic
direction of a business
• Huge levels of executive pay contribute to growing income and wealth inequality in society

Arguments against executive pay ceilings

• Ceiling might prevent talented executives moving to the UK – high rate of pay is a price signal within
the market
• Might lead to businesses re-locating overseas to countries with lower top-rate taxes
• Capping pay and bonuses could lead to rewarding executives in other ways e.g. using complex share
options
• Introducing higher marginal income tax rates on top executive pay might be a better option than
capping
• Caps of say 12 or 20 x the pay of the average worker will impact differently across industries e.g.
average pay is low in the hotel industry compared to financial services in the City of London

Extension idea - Public Sector Pay Policies

Public sector workers include those employed in the armed forces, NHS; the Prison Service; teachers; Civil
Service and the police. Since 2013 the UK Government has funded public sector workforces for average annual
pay awards of 1%. During the period 2011-2013, a public sector pay freeze was in place for public sector
workers excluding those earning £21,000 or less, who received pay increases of at least £250.

Average pay is higher in the public sector than in the private sector. In 2017, median weekly earnings for full-
time employees in the public sector were £599 in the public sector compared to £532 in the private sector. In
part because sector workers tend to be older and more highly-educated. Another factor is that there is a
higher share of jobs in the private sector paying close to the minimum wage.

Supporters of getting rid of public sector wage controls argue that capping pay rises has led to worsening
recruitment problems which now threatens the delivery of public services. Labour shortages may get bigger if
there is a sharp reduction in net inward migration into the UK which would impact on the NHS in particular.
Two counter arguments are that firstly, the pensions are more generous for public sector employees and
secondly, job security is greater.

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4.1.6.7 Discrimination in the labour market

Key specification content:

• The conditions necessary for wage discrimination
• The impact of gender, ethnicity and other forms of discrimination on wages, levels and types of
employment.
• Advantages and disadvantages of discrimination
• Real-world examples expected

Types of labour market discrimination

Labour market discrimination occurs when an employer uses metrics/characteristics other than the measured
productivity of a worker to judge their attractiveness for a job/role
Discrimination can be on the basis of:
• Gender
• Ethnicity / racial profile
• Faith
• Sexuality
• Age
• Height
• Social background
• Any other characteristic

Analysis of Labour Market Discrimination

Wage% • When%discriminating,%
Rate
employers%may%
Labour%Supply perceive%that%that%the%
marginal%revenue%
productivity%of%
W1 “favoured%groups”%is%
relatively%higher%than%
people%subject%to%the%
discrimination

Labour%Demand%(nonB
discriminated%group)

E1 Employment

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 Wage% • The%demand%for%labour%
Rate
of%discriminated%
Labour%Supply groups%will%be%lower%
and%wages%and%
employment%will%be%
W1 lower%as%a%result

W2

LD1
LD%for%discriminated%
group

E2 E1 Employment

The Gender Pay Gap in the UK Labour Market

Evidence for the UK Gender Pay Gap

Median weekly earnings (full-time) in UK, April 2014, by age group and gender

Men Women

700 640
620.2
600 578
536.6 526.6
Median weekly earnings in £s

507.1
500 465.5
435
414.5 411.4
400
301.8
279.9
300

200 164.2
133.8
100

0
16 to 17 18 to 21 22 to 29 30 to 39 40 to 49 50 to 59 60 and over

Factors that may cause a gender pay gap

Despite equal pay legislation in many countries, there remains a persistent gap between male\female pay in
many labour markets
• Breaks from the labour market
o When women take maternity leave to raise a family, it is harder to achieve promotion when
re-entering the jobs market.

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 o Age at which many women take a break from the labour force is often the point when careers
take off
• Access to education: In many developing countries, opportunity for women to take qualifications and
gain experience is limited, affected by social norms, high fertility rates
• Patterns of employment: In developed countries:
o Women are disproportionately represented in part time work
o Many females tend to be clustered in service occupations that pay less – e.g. clerical, caring,
catering, cleaning
o Many women work in vocational professions where wages are relatively lower
• Gender pay gap remains affected by continued employer discrimination
• Increased female participation rates in economies has increased the supply of labour which may have
contributed to lower relative wages

Median UK gender pay gap of full-time employees in the UK as of April 2017, by industry

Median pay gap

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0%

Financial and insurance 31%

Professional, scientific and technical 19.5%
Manufacturing 18%
Health and social work 15.5%
Information and communication 15.5%
Other services 13.5%
Education 13%
Wholesale and retail 12%
Arts, entertainment and recreation 11%
Public administration and defence 10.5%
All employees 9.5%
Real estate 9%
Construction 8.5%
Accommodation and food services 6.5%
Administrative and support services 5.5%

Extension material

Main causes of differentials in wages between occupations

One key feature of the UK labour market is the big dispersion in pay across different occupations and
industries. Many of the reasons why differentials exist relate simply to differences in labour demand and labour
supply. Key factors might include:

1. Compensating wage differentials – these might be a reward for risk-taking, working in poor conditions
and during unsocial hours.
2. Reward for human capital – differentials compensate workers for (opportunity and direct) costs of
human capital acquisition.
3. Different skill levels – market demand for skilled labour (with inelastic supply) grows more quickly than
for semi-skilled workers.
4. Differences in labour productivity and revenue creation - workers whose efficiency is high and
generate revenue for a firm often have higher pay.
5. Trade unions who might use their collective bargaining power – to achieve a mark-up on wages
compared to non-union members
6. Artificial barriers to labour supply e.g. professional exams, migration controls

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 7. Employer discrimination - a factor that cannot be ignored despite many years of equal pay legislation
in place

Current labour market issues

The Gig Economy

• One definition of the Gig Economy is that it is fragmented work where someone is given a task for a
certain amount of time. People provide a service nearly always through a digital platform.
• The Gig Economy is a labour market characterised by the prevalence of short-term contracts or
freelance work
• Well-known Gig Economy businesses include Uber, Amazon, UberEATS, TaskRabbit, Hermes and
Deliveroo.
• In the gig economy, companies hire contingent workers i.e. provisional employees who work for the
organisation on a non-permanent basis.
• 4% of UK working adults aged between 18 and 70 are working in the ‘gig economy’ according to a
recent report - equivalent to around 1.1 million people.
• Some of the rapid growth of the GIG economy can be traced to the impact of the last recession.
Many employers now see short term contract work as a way of de-risking in an age of economic
uncertainty.

Benefits from the Gig Economy

Many people like having a more flexible employment path - more self-employed people in Europe and the
US report enjoying their jobs than those who are employed. A Deloitte in 2018 argued that “In the UK the
great majority of those who work part-time do so out of choice, not for want to a full-time job.” Two-way
flexibility benefitting both businesses and workers is arguably more important than one-way flexibility
favouring a firm

Benefits for businesses

1. Reduces fixed costs – lower payroll expenses
2. Reduced investment – e.g. Uber drivers own their own vehicles
3. Flexibility in managing hours to expected demand for their products

Benefits for workers

1. Flexible hours / control over when to work
2. Ability to work from home (more autonomy)
3. A common way for people to earn extra income
4. Less risk of getting stuck in routine jobs

Evaluation: Drawbacks from the Gig Economy

For workers
1. Doubts over the true flexibility of hours offered by employers
2. Lack of paid vacation/sick leave/employment rights
3. Job and income uncertainty make it harder to get a mortgage – many people are in precarious jobs
4. Inadequate investment in worker training
5. Workers bear most of the risk in their job – often incomes are lower for the self-employed

Wider downsides
1. Shrinking of the tax base will hit revenues
2. Reductions in road safety / more accidents e.g. from delivery drivers using un-licenced vehicles
3. Are platform businesses creating high-quality jobs?

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According to a 2018 House of Commons Select Committee report, “Self-employment (linked to the Gig
Economy) is neither inherently good nor bad. It can represent entrepreneurial zeal and a highly desirable
culture of self-reliance. It can also be deeply negative, allowing companies to evade responsibility for their
workers’ wellbeing and increase their profits. It is incumbent on Government to close loopholes that incentivize
this behaviour.”

Ageing Population in the UK

The UK has an ageing population: there are around 12.4 million people of pensionable age today. Population
projections predict that there will be 16.3 million people of pensionable age in the UK by 2041.

Population of pension age:

• 2016: 12,435,000 (19 per cent)
• 2041: 16,275,000 (22 per cent)

Population older than 75 years:)

• 2016: 5,326,000 (8 per cent)
• 2041: 9,797,000 (13 per cent)

Forecasted population of United Kingdom in 2015, 2025 and 2035, by age group (in million people)
0-14 15-34 35-44 45-54 55-64 65+

80

70
Population (in million people)

16.9
13.95
60 11.85
50 8.99 8.28
7.53
40 9.25 8.47 9.17

30 8.45 9.14 8.8

16.82 16.34 16.88
20

10
11.5 12.19 11.86
0
2015 2025 2035

Possible microeconomic effects of an ageing Possible macroeconomic effects of an ageing

population population
Changing patterns of consumer demand in Impact on government welfare spending and
markets / affecting profits of businesses in future tax revenues e.g. NHS care
particular sectors
Impact on housing market e.g. if people can live in Impact on the rate of growth of productivity and
their own homes for longer long-term GDP growth
Impact on labour market for different jobs – labour Impact on UK competitiveness if the median age
demand and labour supply consequences to continues to rise rapidly
consider

Robotics and artificial intelligence

In the United States, claims a 2013 paper by two Oxford academics, 47% percent of jobs are at “high risk” of
being automated within the next 20 years – 54% of lost jobs will be in finance.

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 Possible microeconomic effects of robotics Possible macroeconomic effects of robotics
Impact on productivity, costs and profits of Effects on employment & unemployment from
firms/industries at cutting edge extensive capital-labour substitution
Impact on demand for, supply of labour in specific Effects on competitiveness and exports and
jobs and the real wages paid changing patterns of trade
Impact on consumer welfare e.g. through lower Effects on government finances e.g. if tax revenues
prices, higher real disposable incomes, economic- from employment fall
wellbeing

Labour Migration
After a number of years of high levels of net inward migration of labour, the net flow of workers entering the
UK labour market has slowed which is in part the result of the June 2016 Brexit referendum. A decline in net
inward migration has an impact on both the demand and the supply-side of the labour market and can affect
both real wages and employment in a large number of different occupations and industries.

Net migration into the UK peaked in 2015 at 336 thousand, when the number of migrants coming into the
country was estimated to have been 644 thousand, compared with 308 thousand leaving.

Inflow Outflow Net migration

800 644 638 585 614

536 552
600 493
Migration in thousands

336 327
400 236 243 271
184 175
200
0
-200
-400
-352 -318 -316 -308 -311 -349 -344
-600
2012 2013 2014 2015 2016 2017* 2018*

Possible microeconomic effects of a fall in net Possible macroeconomic effects of a fall in labour
labour migration migration
Shortages of skilled labour e.g. in the National Fall in net outflow of remittances – impact on UK
Health Service, construction current account of BoP
Impact on demand for and prices of properties to Impact on employment and unemployment if
buy and to rent aggregate labour supply contracts
Effects on dynamic efficiency e.g. with a brain Consequences for economic growth and inflation
drain of entrepreneurs / scientists e.g. from slower growth of AD + possible fall in
LRAS

Zero Hours Contracts

Zero hours contracts do not guarantee a minimum number of working hours each week. In the UK labour
market, people on “zero-hours contracts” are more likely to be young, part time, women, or in full-time
education when compared with others in employment.

There has been an increase in the number of people employed on zero-hour contracts in the UK labour
market. In 2000, there were 225 thousand people on zero-hour contracts, with this number increasing to
approximately 780 thousand by 2018.

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Number of people in the UK counted as being on zero-hours contracts
1000
903 883
900
780
800 747
Employees in thousands

700 624
585
600
500
400
300 225 252
176 166 189 168 190
200 156 147 143
124 108 119
100
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Arguments in favour of zero hours

1. Supporters of flexible employment contracts argue that they are good for businesses where demand
and production is highly seasonal - for example in retailing, brewing, tourism and catering. Employing
people on a zero-hour contract may allow businesses to better control their costs.
2. Zero-hours contracts might also benefit some people who want a high level of flexibility in choosing
when they want to work.

Arguments against zero hours

1. A counter argument is that zero-hour contracts have contributed to an increase in "in-work poverty"
where people are not able to work enough hours each week (often at relatively low wage rates) to
earn sufficient to avoid remaining in poverty and reliant on top-up welfare benefits.
2. Uncertain incomes also make it harder for people to be given loans, mortgages and mobile phone
contracts

Government intervention in the labour market

Interventions to improve labour mobility and incentives

Policies to improve mobility and incentives might focus on:
1. Providing access to better quality training within firms – a good example is the Workplace Levy
2. Better funding for technical / vocational education – a good example is the new T-level qualifications
3. Improving the affordability and reliability of transportation – e.g. using subsidies for bus & rail travel
4. Addressing chronic housing shortages / expensive rents – perhaps through a maximum rent
5. Creating a bigger difference between pay/earnings in work and welfare benefits for those without a
job
6. Lowering the burden of direct taxes especially for families on low incomes to encourage work
incentives
7. Raising the level of the statutory national minimum wage
8. Providing tax-free childcare for all children aged 3 and over

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Labour Market Economics Key Definitions and Measurements

Age dependency Age dependency = (people younger than 15 and older than 64) / (working age
ratio people ages 15-64).
Capital labour Replacing workers with machines in a bid to increase productivity and reduce the unit
substitution cost of production
Demand for The number of workers a firm is willing and able to employ at each wage rate
labour
Derived demand Demand for a factor of production as a result of demand for the final product that
that factor of production can produce
Discouraged People out of work for a long time who may give up on job search and leave the
workers labour market
Discrimination Different treatment of people based on age, gender, race, sexual orientation,
ethnicity
Economic People who are out of work and not looking for a job
inactivity
Economic rent Any amount earned by someone above the minimum amount they require to work
Full employment When there enough unfilled job vacancies for all the unemployed to take paid work
Gender pay gap Percentage difference between men's and women’s median hourly earnings
Geographical Barriers to people moving within and between areas and regions to find work
immobility of
labour
Gig economy Fragmented work where someone is given a task for a certain amount of time e.g.
delivery couriers
Gini coefficient A measure of income inequality in a country, where 0 represents complete equality
and 1 represents complete inequality.
Human capital The amount of skill, knowledge, talent, experience and ability of workers.
Labour force All people who are of working age, and able and willing to work. It includes both the
employed, and the unemployed.
Labour supply The quantity of people willing and able to work in an occupation or industry at the
prevailing wage rate
Labour-intensive Labour-intensive production relies mainly on labour e.g. food processing,
production hairdressing, fruit farming
Living wage Hourly pay that provides enough money for a working person to live decently and
provide for their family.
Long term People who have been out of work for at least one year
unemployed
Marginal revenue Extra revenue generated when an additional worker is employed.
product
Minimum wage A statutory (legal) pay floor in the labour market
Money wages Also known as "nominal wages"; the actual hourly rate of pay - it is not adjusted for
inflation
Monopsony A labour market structure in which there is a single powerful buyer of a particular
employer type of labour.
Participation rate Proportion of the population of working age that is in the labour force (either
employed or unemployed).
Poverty trap Situation in which there is no incentive for workers earning a low income to earn
extra income, because it would result in having to either pay higher tax and/or losing
some of their benefit payments
Real wage The hourly rate of pay adjusted for inflation

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 Relative poverty A household is in relative poverty (also called relative low income) if its income is
below 60% of the median household income.
Trade Union A collective of workers that bargains with employers to improve pay and working
conditions
Transfer earnings The minimum reward required to keep factors of production, such as labour, in its
current occupation.
Union density Percentage of a particular labour force that belongs to a trade union
Universal credit Single monthly benefit designed to replace 6 separate benefits for people who are
on low income or out of work.
Wage elasticity of The responsiveness of the demand for labour to a change in the wage rate of labour.
demand for Calculated using the formula: %ΔDL ÷ %ΔW
labour
Working poverty A situation where families with at least one person in paid work have a household
income that keeps them below an officially recognised poverty line
Zero hours Jobs that do not guarantee a minimum number of working hours each week
contracts

Examiner tip

Make sure that you stay completely up to date with developments and trends in labour markets. It will be
helpful for you in both microeconomics and macroeconomics!

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4.1.7.1 The distribution of income and wealth

Key specification content:

• The difference between income and wealth and factors influencing its distribution
• The difference between equity and equality
• The Lorenz curve and Gini coefficient and their interpretation but not calculation
• The likely benefits and costs of a more equal or more unequal distribution and an appreciation
that this involves value judgements, which in turn will influence possible policy prescriptions
• Knowledge of UK income and wealth distribution
• Excessive inequality is a cause and consequence of market failure

Difference between Income & Wealth

Income Wealth
Income is a flow of money going to factors Wealth is the current value of a stock of
of production assets owned by someone or society as a
whole
Wages and salaries from jobs Savings in bank accounts
Rental income from property Ownership of property
Interest from savings Shares / stocks in businesses
Profits flowing to shareholders Wealth held in pension schemes

Factors influencing inequality

• Skills bias arising from technological change – super-high pay for some people
• Rising share of capital income – concentrated among the rich (Piketty)
• Tax systems have become less progressive + Welfare cuts
• Executive pay and bonuses rising faster than for ordinary employees
• Rise in scale of in-work poverty, reduced employee bargaining power
• Increasing urban-rural and deep regional economic inequalities
• Hollowing out of employment in manufacturing, increasing economic inactivity

Measuring Inequality
• Gini Coefficient
o Overall measure of income equality, a value of 1 is perfect inequality; a value of zero means
no inequality
• Palma Ratio
o Ratio of income of the top 10% of income households divided by the income to the poorest
40%

Income Inequality in the UK

Recent publications from Parliament and the ONS suggest that the tax and benefits redistribution system in
the UK does not reduce the value of the Gini coefficient by as much as it does in other countries that have a
similar “original income” Gini coefficient. The impact of the tax and benefits system in the UK can be seen on
the following chart.

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 UK Gini Coefficient over time
by original income, gross income, and disposable income
60

50

40

30

20

10

0
1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
- - - - - - - - - - - -
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

Original Gross Disposable

Quick question

How has the UK’s Gini coefficient, and therefore level of inequality, changed over time? How effective do
you think the tax and benefit system is at reducing inequality?

The chart below shows the UK’s average income over time. Clearly income has risen over the period shown.
But there is an increasing divergence between the mean income and the median income, as the mean
continues to be ‘pulled upwards’ by a small number of very high earners.

UK average income over time

mean and median
1977 = 100
260
240
220
200
180
160
140
120
100
80
81

91

to 6
20 to 2 4
87

2
79

4
83
85

89

20 to 2 0
20 to 2 2

11 010

18
77

97 99

17 01
09 00

13 01
05 00
07 00
95 99

99 99

01 00
03 00

15 01
19

19

20
19
19

19
19
19

19

20 to 2
20 to 2
20 o 2

20 to 2
19 to 1

20 to 2
1

19 to 1
20 to 2

t
19

Median Mean

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The relationship between equity and efficiency

It is widely believed that persistent deep poverty is a major barrier to economic growth and development.
Hence the importance attached by many countries to introducing effective poverty-reduction strategies.

The impact of high rates of extreme poverty and deep inequality include:
• Low life expectancy and fewer years of healthy life expectancy
• Low school enrolment rates as families cannot afford education - widens the gender opportunity gap
• Low access to basic health care
• Vulnerability to loan sharks for families mired in debt
• Limited access to technology
• Threats to democracy and stable institutions
• Low real spending power limits the size of markets for consumer goods and services

Consequences of high relative poverty (inequality) for economic growth

• Causes a self-perpetuating poverty cycle
o Limited access to health care and education
o Volatile incomes, high debts + low savings
• Misallocation of scarce resources
o Capital investment in society is skewed towards the preferences of the rich
o Low collateral – limits growth of entrepreneurship
• Social and political unrest / tensions
o Increased pressure on state welfare systems
o Rise of the informal economy + high interest rate loans (e.g. doorstep lenders)

Can inequality drive economic growth?

1. To encourage competition and effort among workforce – consider rewards in sports tournaments!
2. Incentivizes risk- taking behaviour by entrepreneurs + incentives to invest in education – both good
for innovative / competitiveness
3. In poor economies, inequality also helps to build up market demand for certain consumer goods that
require a minimum purchasing power (e.g. cars, household appliances).

UK income distribution by ethnic group

Data from the UK government shows that, after housing costs were deducted:

• White British households had the largest percentage of households in the highest income quintile
(21%), and the smallest percentage in the lowest income quintile (17%)

• Bangladeshi households had the smallest percentage of households in the highest income quintile
(4%), and the largest percentage in the lowest income quintile (44%)

• the ethnic groups with the largest percentage of households in the 2 lowest quintiles were Pakistani
(76%), Bangladeshi (74%) and Black (62%)

• by comparison, 37% of White British households fell into the 2 lowest income quintiles

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UK wealth inequality

UK wealth by financial asset (£m)

according to income decile
2016

Decile 10 (Highest)

Decile 9

Decile 8

Decile 7

Decile 6

Decile 5

Decile 4

Decile 3

Decile 2

Decile 1 (Lowest)

0 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000

All Current accounts Savings accounts

ISAs National Savings certificates and bonds
UK shares Insurance products
Fixed term bonds PEPs
Employee shares and share options Unit/Investment trusts
Overseas shares UK bonds/gilts
Overseas bonds/gilts Other formal financial assets

The Lorenz Curve

• The Lorenz Curve gives a visual interpretation of income or wealth inequality.
• The diagonal line shows a situation of perfect equality of income i.e. 50% of population has 50% of
income

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 Cumulative*%*of*Income
100%
Line*of* Equality

50%

Lorenz*Curve*
(Low*Inequality)

Lorenz*Curve*
(High*Inequality)
0%
Poorest Richest
Households* by*Income*– Quintile* Distribution

Extension material: using the Lorenz Curve to measure the Gini Coefficient
• The Gini coefficient condenses the entire income distribution for a country into a single number
between 0 and 1: the higher the number, the greater the degree of income inequality.
• The Gini coefficient ranges from zero, when everyone has the same income, to 1, when a single
individual receives all the income
• A Gini coefficient above 0.4 is often seen as an important point. Inequality above this level is frequently
associated with political instability and growing social tensions.

Cumulative*%*of*Income
100%
Line*of* Equality

Gini*coefficient*=*
Area*A
Divided* by
Area*A*+*Area*B

A
Lorenz*Curve

B
0%
Poorest Richest
Households* by*Income*– Quintile* Distribution

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4.1.7.2 The problem of poverty

Key specification content:

• The difference between relative and absolute poverty

• The causes and effects of poverty

The Difference between Absolute and Relative Poverty

• Absolute poverty:
o When a household does not have sufficient income to sustain even a basic acceptable
standard of living / meet basic needs
o Absolute poverty thresholds will vary between developed and developing countries
o The extreme poverty measure now used by the World Bank is the percentage of the
population living on less than $1.90 a day (PPP)
• Relative poverty
o A level of household income that is considerably lower than the median level of income
within a country
o The official UK relative poverty line is household disposable income (adjusted for household
size) of less than 60% of median income
• The official poverty line:
o An income level that is considered minimally sufficient to sustain a family in terms of food,
housing, clothing, medical needs, and so on.

Main Causes of Absolute (Extreme) Poverty

Absolute or extreme poverty is an inability to meet basic needs. In many countries, significant progress has
been made in reducing absolute poverty but each year the Human Development Report makes clear how
much progress remains to be made
• Population growing faster than GDP in low income countries
• Severe savings gap - families unable to save and living on less than $1.90 per day
• Absence of basic government / public services
• Effects of endemic corruption in government and business
• High levels of debt and high interest rates
• Damaging effects of civil wars and natural disasters
• Low employment rates, vulnerable jobs and poverty wages
• Absence of basic property rights

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4.1.7.3 Government policies to alleviate poverty and to influence the
distribution of income and wealth

Key specification content:

• Available policies to influence the distribution of income and wealth and alleviate poverty
• The economic consequences of such policies, including recognising the moral and political
perspectives

Government spending and income inequality

• Welfare state transfers
o Universal child benefits / unemployment benefit
o Public (state) pensions
o Conditional welfare transfers e.g. Conditional on attending unemployment programmes
o Targeted welfare payments- linked to income
• State-provided services (in-kind benefits)
o Education - reduces inequality of market incomes
o Health care – state provided health services
o Social housing e.g. Provided by local authorities
o Employment training

How taxes and welfare affect the final distribution of income in the UK
1. Original income is income before government intervention e.g. from wages and salaries and
investment incomes including rent and interest.
2. Final income is income after taxes and benefits.

Average income per household (£ per week)

Poorest 2nd 3rd 4th Richest All
20% of Quintile Quintile Quintile 20% of Households
households households
Original 105.8 263.2 476.1 783.5 1548.6 635.4
income
Final 297.1 444.1 543.5 697.6 1150.4 626.6
income

Other policies designed to reduce inequality

• Redistributive welfare transfers
o Higher child benefit and the triple lock on state pensions
o Expanded supported for disadvantaged students in paying tuition fees
o Public goods free at the point of consumption
o Minimum income scheme + capital endowments for young people
• Progressive income, consumption and wealth taxes
o Higher taxes on property
o Increased income tax allowances and higher marginal rate on incomes above £100,000
o Progressive consumption tax
• Strengthening wage floors and employment rights in the labour market
o National Living Wage, rising minimum wage
o Improved employment rights, affordable child care, tackling monopsony employers
• Tackling structural barriers to employment

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 o Early years education and more nutritional school meals to improve brain development
o Improved access to new technologies in disadvantaged communities
o Better vocational education, coding, STEM subjects
o Targeted measures to address long term unemployment

Underlying Causes of Inequality

• Skills bias arising from technological change – super-high pay for some people
• Rising share of capital income – concentrated among the rich (Piketty)
• Tax systems have become less progressive + Welfare cuts
• Executive pay and bonuses rising faster than for ordinary employees
• Rise in scale of in-work poverty, reduced employee bargaining power
• Increasing urban-rural and deep regional economic inequalities
• Hollowing out of employment in manufacturing, increasing economic inactivity

Evaluating Policies to Lower Inequality

Policy Real World Example Brief Analysis Evaluative

Intervention Comment
Higher NMW has risen to Boosts work Might cost some
minimum wage £7.20 per hour from incentives and jobs and lead to
April 2016 take-home pay higher prices
Free provision Free NHS treatment, Access to merit Universal access
of services state education goods not based not as effective as
on ability to pay targeted provision
Higher rates of 45% top rate of Progressive taxes Risk of a brain
income tax income tax might be on the rich lower drain and
raised to 50% again inequality and raise increased tax
revenue avoidance
Investment in Subsidies for Helps to raise Effective in the
training workplace training / productivity, jobs long run but risk of
internships and real wages the free rider
problem
Subsidies for 2014 - max Govt Improve incentives Effective, but
childcare contribution of £2,000 for mothers to look quality of childcare
a year for each child for and take work needs improving

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4.1.8.1 How markets and prices allocate resources

Key specification content:

• The price mechanism and its advantages and disadvantages
• Application to specific markets such as the market for blood

Economic systems

Free Market System Mixed Economy Transition Economy Socialist Planning

An economic system is a network of organisations used to resolve what, how much, how and for whom to
produce i.e. a way of solving the basic economic problem (when there are infinite demands on finite
resources).
1. Free market economy: Markets allocate resources through the price mechanism. An increase in
demand raises price and encourages businesses to put more resources into the production. The
quantity of products consumed by people depends on their income and income itself depends on
the market value of an individual’s work. In a free market system, there is a limited role for the
government, indeed in a pure free market system, the government limits itself to protecting property
rights of people and businesses using the legal system and protecting the value of money or the
value of a currency.
2. Planned or command economy: in a planned or command system associated with a socialist or
communist system, the government owns scarce resources. The state allocates resources and sets
production targets and growth rates according to its own view of people's wants. Market prices play
little or no part in informing resource allocation decisions and queuing rations scarce goods.
3. Mixed economy: In a mixed system, some resources are owned by the public sector (government)
and some are owned by the private sector. The public (or state) sector typically supplies public, quasi-
public and merit goods and intervenes in markets to correct market failure. Nearly all economies in
the world are mixed although that mix changes over time for example as some industries are
privatised (sold to the private sector) or nationalised (taken back into state ownership).

Common error alert!

Students often confuse ‘public sector’ with the ‘public’

Advantages of free market economies:

Competitive markets may create some of the following benefits:

1. An efficient allocation of scarce resources – factor inputs tend to go where the expected profit is
highest, and in turn this represents the goods/services most desired by consumers (economists often
link this to idea of consumer sovereignty).

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 2. Competitive prices for consumers as suppliers look to increase and then protect their market share.
3. Competition drives innovation & invention bringing higher profits for businesses and better products
for consumers – economists often call this dynamic efficiency (you will meet this concept again in
Theme 3).
4. The profit motive stimulates investment which encourages economies of scale (i.e. lower unit costs in
production) and, in turn, lower prices for consumers.
5. Competition through trade helps to reduce domestic monopoly power and increases choice.
6. Historically, economies with a large free-market aspect to resource allocation have grown more
quickly than those with a command economy.

Disadvantages of free market economies:

1. Some members of society may be unable to work e.g. the elderly, those with disabilities or additional
needs, parents with young children etc. Without government intervention, these people will likely live
in poverty. This can create significant inequality in an economy.
2. Goods that are bad for us (often called demerit goods) may be over-produced; these could include
products such as cigarettes and alcohol. Similarly, products that are very good for us (often called
merit goods) may not be consumed in large enough quantities; these could include healthcare and
education (which will not be provided by the government in a completely free-market system).
3. Because of the profit motive, firms may be tempted to cut costs, and so exploit labour (e.g. paying
low wages or using child labour), use environmentally-unsound production methods etc.
4. Some firms may grow so large that they gain significant monopoly power, which allows them to
charge very high prices to consumers, which could be unfair. Without government intervention, there
may be no easy way to prevent this from happening.
5. Public goods (which you will meet later in Theme 1) will not be provided. Examples include streetlights,
free-to-use roads, lighthouses, flood defences etc.

Quick question

Which economy do you think is the closest example of a free-market economy?

Advantages of central planning / command economies

1. There is generally a low level of inequality and a low level of unemployment. Many command
economies have had strong gender equality.
2. Resources are allocated according to the ‘common good’ rather than according to the ‘profit motive’.
This is likely to result in universal provision of healthcare and education, amongst other things.
3. It may be more straightforward / fast to get large-scale infrastructure projects built.

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Problems with central planning / command economies

1. Bureaucratic costs of central planning of resources – petty officialdom can lead to wasteful
inefficiencies and therefore higher costs.
2. Problems in fixing prices of goods and services – planners are unlikely to be as accurate as the market
in determining suitable prices.
3. Absence of incentives for both workers (i.e. no wage ‘differentials’) and businesses (i.e. no ‘profit
motive’) can damage productivity and also lead to large levels of over-employment.
4. Low productivity and weak incentives lead to rising losses for many state-owned businesses. The
incentive to innovate is also limited.
5. Changing consumer needs and wants are not expressed as preferences in markets – the state is often
slow to react to these
6. The state can suffer from information failures and corruption
7. State-run economies are at higher risk of mal-investment driven by political motivations rather than
market-assessed cost-benefit analysis

In reality, most economic systems are “mixed”. That is, some resources are allocated using the market
mechanism, and others by the government. The precise combination of private versus public resource
allocation depends on the economy in question – there is no ‘right’ or ‘wrong’ combination. This is a good
example of a normative issue in economics. Typically in a mixed economy, the government will collect taxes
to a) help ‘redistribute’ income from the rich to the poor, and b) to provide the goods and services its regards
as essential.

Quick questions

In the UK, which resources are provided by the government?

Are there are resources currently provided by the market mechanism that you think would be better
provided by the government?

Extension topic: Adam Smith on economic systems

In his 1776 book ‘Wealth of Nations’, Adam Smith (amongst many other things!) wrote about the ‘invisible
hand’ of resource allocation, and the role of ‘self-interest’, in an early reference to free-market economies.
The key quotes from Wealth of Nations on this topic are:

“[Every individual] generally, indeed, neither intends to promote the public interest, nor knows how much
he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his
own security; and by directing that industry in such a manner as its produce may be of the greatest value,
he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote
an end which was no part of his intention. Nor is it always the worse for the society that it was no part of
it. By pursuing his own interest he frequently promotes that of the society more effectually than when he
really intends to promote it. I have never known much good done by those who affected to trade for the
public good.”

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 “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but
from their regard to their own interest. We address ourselves, not to their humanity but to their self-love,
and never talk to them of our own necessities but of their advantages.”

At the same time, however, Adam Smith warned that we should be wary of businesses that become too
large (i.e. monopolies) because of their tendency to raise prices. He recognised that the government should
keep an eye on their activities, but believed it was dangerous for large businesses to influence politics and
legislation.

Smith also recognised that in a free market economy, some people would be rich ‘property owners’ i.e.
owners of the factors of production, and there would be far fewer of these people than labourers. He said
that one important role of government in this type of economic system would be to maintain law and
order, because the many poor would want to take over the property of the rich.

Other roles for the government, identified by Smith, include the issuing of patents and copyright (to protect
invention), providing national defence, regulating the banking sector, building infrastructure, and public
goods.

Smith is now regarded as the founder of free market (or laissez-faire) economics, despite recognising the
need for some government intervention.

Extension topic: Karl Marx and economic systems

Marx developed many of Adam Smith’s ideas on capitalism / free-market economics, but mostly considered
the negative consequences. He agreed that free markets would lead to large increases in productivity and
output, but also thought that the impact on labourers would be terrible. Marx believed that the drive for
profit by business owners in the capitalist system would push worker wages to ‘subsistence’ levels and that
they would be exploited. He said that, ultimately, exploited workers would work together and overthrow
capitalism in a revolution. Capitalism would be replaced by socialism. In this system, production would be
coordinated centrally, and distribution of the goods made would be “to each according to his contribution”.
Beyond this, though, Max gave very little indication of how he thought a centrally-planned command
economy would operate in practice.

Extension topic: Friedrich Hayek and economic systems

Hayek is probably the best-known member of what is known as the Austrian School of economics, in which
there is a strong belief in the role and importance of the individual in the economy, rather than any
collective group or government. During the 1930s, he engaged in lively debate with the economist Keynes
– Keynes supported significant government intervention in the economy to stimulate growth whereas
Hayek did not.

Whereas Adam Smith saw a role for government intervention in money markets and financial markets,
Hayek disagreed, arguing that intervention in money markets was one of the main causes of economic
instability (the pattern of booms and recessions). In other words, Hayek saw less of a role for governments
in an economy than even Smith. For Hayek, the only possible role for a government was to maintain law
and order. Later in life, he did suggest that the state could provide a small ‘safety net’ for those who found
themselves unable to work.

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 Hayek also argued strongly against command economies, noting that a small group of individuals would
be entirely responsible for determining the allocation and distribution of resources; in his view, it would be
completely impossible for them to ever have enough information to do this properly to meet people’s
needs. Hayek believed that markets alone would have the information needed to make these decisions,
because markets coordinate the views and information held by everyone, in a ‘spontaneous’ way.

Quick question

Which of the three economists just mentioned do you think you most closely agree with, and why?

Examiner tip

Referring to the work of economists in exam answers is often a very good way to build strong knowledge
marks.

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4.1.8.2 The meaning of market failure

Key specification content:

• Market failure occurs whenever there is a misallocation of resources
• The difference between complete and partial market failure
• Market failures can be caused by public goods, positive and negative externalities, merit and demerit
goods, monopoly and other market imperfections and inequalities.

Negative Positive Public goods Information Monopolies / Immobility and

(production) (consumption) failures market power inequality
externalities externalities (including merit
& demerit
goods)

What is market failure?

The main role of prices in a market economy is to allocate scarce resources efficiently. Market failure exists
when the competitive outcome of markets is not efficient (or equitable) from the point of view of the economy
as a whole i.e. resources are not allocated as efficiently as they could be. This is usually because the benefits
that the market confers on individuals or firms carrying out a particular activity diverge from the benefits to
society as a whole.
.

Partial and complete market failure

Complete market failure occurs when the market does not supply products at all – there is a missing market.
For your A level, the main reason that you need to consider for missing markets is public goods. This concept
will be covered in more detail later in this course companion. In some circumstances, information failure such
as asymmetric information can lead to missing markets as can lack of property rights, such as exist with
externalities.

Partial market failure occurs when the market functions / exists, but it supplies either the wrong quantity of a
product or at the wrong price. Examples needed for your A level include externalities from production and
consumption, some information gaps, market concentration and frictions, and irrationality (such as that
identified by behavioural economics). Inequality can also be a cause of partial market failure, particularly
regarding allocative efficiency, as some groups are not able to express their preferences through effective
demand. When prices are very volatile, this may also be thought of by some as leading to a market failure if
some, particularly vulnerable groups in society are affected. Merit and demerit goods are particular types of
goods that combine a number of these characteristics. A merit good for example is associated with an
irrational (and incorrect) evaluation of benefits, positive consumption externalities and it is a good that society
feels individuals should be able to consume irrespective of their ability to pay.

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4.1.8.3 Public goods, private goods and quasi-public goods

Key specification content:

• Characteristics of private and public goods
• Circumstances where goods may be quasi-public
• The significance of technological change on excludability in particular
• The free-rider problem
• Tragedy of the commons, with particular reference to environmental market failure

What are public goods?

Sanitation Flood defence Crime control for Reduced risk of Freely available Public service
infrastructure projects a community disease from knowledge e.g. broadcasting
vaccinations online learning
Public goods cause market failure due to the problem of missing markets. Public goods are also sometimes
referred to as collective consumption goods. Public goods are characterised as being both non-rival and non-
excludable.

Private Goods
A private good or service has two main characteristics:
1. Excludable: A ticket to the theatre or pay-per-view sporting events are private goods because buyers
can be excluded from enjoying the product if they are not willing and able to pay for it. Excludability
gives the seller the chance to make a profit. When goods are excludable, the owners can exercise
property rights.
2. Rival in consumption: If you enjoy a pizza from Dominos, that pizza is no longer available to someone
else. Likewise driving a car on a road uses up road space that is no longer available at that time to
another motorist. With a private good, one person's consumption of a product reduces the amount
left for others to consume and benefit from - because scarce resources are used up in supplying the
product.
We can also describe private goods as being rejectable. So,if you don't like the soup on the school menu, you
can use your money to buy something else! You can choose not to travel on Virgin Rail and go instead by
coach, or you can choose not to buy a season ticket for your local football club and instead use the money to
finance a subscription to a health club. The consumer can reject private goods and services if their needs and
preferences or their budget changes.

Key Characteristics of Public Goods

The two main characteristics of pure public goods are the opposite of private goods:
1. Non-excludability: The benefits derived from pure public goods cannot be confined solely to those
who have paid for it. Non-payers can enjoy the benefits of consumption at no financial cost –
economists call this the ‘free-rider’ problem.
2. Non-rival consumption: Consumption by one consumer does not restrict consumption by other
consumers – in other words the marginal cost of supplying a public good to an extra person is zero.
If it is supplied to one person, it is available to all.

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As with private goods, we can also describe public goods as being non-rejectable. That is, the collective supply
of a public good for all means that people cannot reject it, a good example is a nuclear defence system or
major flood defence projects affecting an entire community.

Public goods and market failure

• Private sector markets may fail to supply in part or in whole the optimum quantity of public goods
• Pure public goods are not normally provided by the private sector because they would be unable to
supply them for a profit (due to the free rider problem…if a good is non-excludable, then it becomes
impossible to charge anyone for consuming it…and without being able to charge a price, then a firm
would gain no revenue at all)
• It is up to the government to decide what output of public goods is appropriate for society.
• To do this, it must estimate the net social benefits from making public goods available. Governments
do not have to provide public goods.

Examiner tip:
Many students get confused about the definition and nature of public goods in exams. Too frequently,
students write that public goods are provided by the government as their defining feature – however, public
sector provision is usually the solution to this market failure and in no way constitutes the nature of a public
good. A public good is not one that is provided by the public sector!

Every time you see the phrase ‘public goods’ in an exam, the first two things you should write down are that
public goods are both non-rival and non-excludable. Questions often ask about “the extent to which a
particular good is public or not”. Students need to then establish whether the good in question is both non-
rival and non-excludable, and then consider circumstances in which it might not e.g. a busy beach on a hot
sunny day. Public goods can sometimes be quasi-public i.e. either non-rival or non-excludable, but not both.
This is covered in more detail below.

Quasi-Public Goods

Crowded beaches Toll roads and bridges

A quasi-public good is a near-public good. It has some of the characteristics of a public good. Quasi-public
goods are:

1. Semi-non-rival: up to a point, more consumers using a park or road do not reduce the space available
for others. But beaches can become crowded as do parks/leisure facilities. Open-access Wi-Fi
networks become crowded
2. Semi-non-excludable: it is possible but difficult or costly to exclude non-paying consumers. E.g.
fencing a park or beach and charging an entrance fee; or toll booths
So, quasi-public goods are either non-rival or non-excludable, but not both.

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The Free-Rider Problem

Accessing Open Open access to free

Fare Dodging Fly Tipping
Spaces Wi-Fi

Downloading /
Tax evasion
sharing

Because public goods are non-excludable it is difficult to charge people for benefitting once a product is made
available. People who use the good/service once it is provided and do not pay are known as free riders. Free
riders have no incentive to reveal how much they are willing and able to pay for a public good. The free rider
problem leads to under-provision of a good and thus causes market failure; in the case of public goods,
because everyone would be a free rider, the good is not provided at all by the private sector because they
would be unable to supply it for a profit.

Case for government intervention with public goods

• The non-rival nature of consumption provides a strong case for the government to replace the market
to provide and pay for public goods
• Many public goods are provided free at the point of use and funded by taxation or a charge such as
the BBC’s licence fee
• State provision may help to prevent under-provision and under-consumption of public goods so that
social welfare is improved
• If the government provides public goods, they may do so more efficiently because of economies of
scale
• Providing essential public goods helps affordability and access to important services for lower income
households and therefore help to address inequalities of income
Arguments against state provision
• If the government becomes a monopoly provider, there is a danger of a lack of efficiency arising from
a lack of competition
• There are many other demands on government finances, and so there could be a significant
opportunity cost of public goods being provided. In some cases, the state funds and the private sector
provides public goods e.g. via Public Private Partnerships / Private Finance Initiative – although the
track record on many of these projects suggests that the long-term cost is quite high.

Technology and the Changing Nature of Public Goods

Advances in technology are causing a blurring of the distinction between public and private goods. For
example, in some cases, encryption allows suppliers to exclude non-payers – although the product remains
non-rival e.g. subscription TV.

Technological progress also reduces the cost of smart metering used in road pricing – this makes roads more
of a private (excludable) good. The open source / creative commons movement has made much information
public good in nature.

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 Encryption devices Smart Electronic Road Open Source Software Live Streaming of
Pricing Events

Extension idea: the importance of property rights

Property rights confer legal control or ownership. For markets to operate efficiently, property rights must be
protected – perhaps through regulation. Put another way, if an asset is un-owned, no one has an incentive to
protect it from abuse. The right to own property is essential in a market-based system

Failure to protect property rights may lead to what is known as the Tragedy of the Commons - examples
include the over-use of common land and the long-term decline of fish stocks caused by over-fishing which
leads to long term permanent damage to the stock of natural resources. In this situation, individual users of
the asset (e.g. grazing land, the sea) aim to maximise their own utility, but in doing so, reduce the benefits for
everyone, and ultimately themselves, as the resource is over-used.

Extension idea: common pool goods and club goods

What is a common pool resource?
• When no one owns a resource, it may get over-used, for example fish stocks and deforestation -
people (acting in their own self-interest) benefit from using a common pool resource such as grazing
land without regard to the effect it has on other producers.
• Over-use of a renewable resource can lead to a long-term decline in maximum sustainable yield. This
is known as the tragedy of the commons.
What is a club good?
• Club goods are excludable but non-rival. For example, Wi-Fi internet access in a coffee store is
excludable but non-rival (normally) as extra users log on to the network.

Quick question

Think about some of the goods and services provided by the government. Which of them are public goods?
Which of them are more likely to be goods with positive externalities, that the government has decided to
provide?

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4.1.8.4 Positive and negative externalities in consumption and production

Key specification content:

• Externalities exist when there is a divergence between private and social costs and benefits.
• Negative externalities are likely to result in over-production and positive externalities in under-
production
• It is the absence of property rights that leads to externalities in both consumption and production
and hence market failure.
• You are expected to use diagrams to illustrate the misallocation of resources

What are externalities?

Externalities are spill-over effects from production and/or consumption for which no appropriate
compensation is paid to one or more third parties affected. Put differently, externalities are impacts on ‘third
parties’ (i.e. people not directly involved in the market transaction – they are neither the buyer nor the seller)
as a result of a market transaction.

Because externalities lie outside the initial market transaction, they are not reflected in the market price.
Externalities cause market failure if the price mechanism does not take account of the full social costs and
benefits of production and consumption. Externalities can be positive and/or negative i.e. the impacts on third
parties can be good or bad.

Private costs, external costs and social costs

• Private costs are the costs faced by the producer or consumer directly involved in a transaction
• External costs are the costs imposed on third parties as a result of a transaction that they are not
directly involved in (note - “external costs” is a synonym for negative externalities)
• Social cost = private costs plus external costs
• Therefore, when negative (production) externalities exist, social costs exceed private cost
• External costs occur when the activity of one agent has a negative effect on the wellbeing of a third
party
• External costs damage third parties, but the consumer and producer don’t have to pay, meaning that
output will be too high. In the case of production externalities, the market price will therefore be too
low

Common error alert!

The terms ‘social cost’ and ‘external cost’ are often confused by students. External costs simply affect third
parties whereas social costs affect third parties and those directly involved in the market transaction.

Multiple choice questions on this topic often consider this common error, so be careful!

Examiner tip:

AQA like you to show production externalities on the supply curve. Refer to the externalities as costs.
Consumption externalities are shown on the demand curve and are referred to as benefits.

If you are taking an AS exam, the terminology used is different. See the diagrams below:

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Negative production externalities

Negative consumption externalities / demerit good

Extension idea: valuing externalities

A key aspect of all externalities is the difficulty of assigning values. There are several ways in which economists
believe that they can be valued:

1. Shadow pricing: e.g. the external cost of road congestion can be calculated by multiplying the number
of hours lost by the average wage e.g. 1m lost working hours x £12 average hourly wage = £12m
2. Compensation: estimate the cost of ‘putting right’ an externality e.g. includes the cost of installing
double-glazing in houses affected by increased road noise from a new motorway. If 200 houses are
affected each with £5,000 double glazing cost, increased road noise is estimated at £1m
3. Revealed preference: how much people are willing to pay to avoid an externality e.g. if 200
householders are willing to pay £2,000 each to avoid noise, the externality is valued at £0.4m

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Examiner tip:

Noting that it is virtually impossible to put a price on externalities helps with evaluation of the effectiveness of
policies to tackle externalities. For example, governments may decide to use an indirect tax to reduce
production to the socially optimal level, but this requires them to set the indirect tax equal to the value of the
external cost – this is not possible if we cannot value the external cost, so as a result the government
intervention may be ineffective.

Additional key definitions:

When drawing diagrams and carrying out detailed analysis of externalities, economists work “at the margin”
i.e. considering the impact of one more unit of consumption / production. Additional key terms that are
needed for understanding negative production externalities are:

• Marginal private cost (MPC): cost to the producing firm of producing an additional unit of output or
costs to an individual of any economic action
• Marginal external cost (MEC): cost to third parties from the production of an additional unit of output
• Marginal social cost (MSC): total cost to society of producing an extra unit of output. MSC = MPC +
MEC

Calculating Social Costs and Benefits – A Worked Example

A government is considering four investment projects. It has the resources to finance only one of these
projects:

New city New schools Airport extension New hospitals

motorway
Private benefits 50 135 130 90
Private costs 120 80 100 65
Positive externalities 90 55 35 120
Negative 60 20 60 45
externalities
Net private benefit -70 +55 +30 +35
Net social benefit -40 +90 +5 +100

In this example, the largest net social benefit is highest for building new hospitals. Net social benefit may be
considered by a government when deciding which project offers the best potential return for society.

Examples of negative externalities from production

Production externalities are generated and received in supplying goods and services - examples include noise
and atmospheric pollution from factories and discharges of waste.

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 Air pollution from factories Pollution from fertilizers Industrial waste

Noise pollution Collapsing fish stocks Methane emissions

Illustrating negative production externalities on a diagram:

• If there are negative externalities, then we must add the external costs to the firm’s supply curve (i.e.
it’s marginal private cost (MPC) curve) to find the marginal social cost curve (MSC)
• If the market fails to include these external costs, the private equilibrium output is Q1 and the price P1
where marginal private cost = marginal private benefit.
• The socially efficient output would be Q2 with a higher price P2. At this price level, the external costs
have been considered, and marginal social cost is equal to marginal social benefit
• We have not eliminated the pollution – but at least the market has recognised them and priced them
into the price of the product.
• For economists, it is rarely the case that products generating external costs should have production
levels of zero – we recognise that there are usually some benefits to these products being provided!

Costs,( The(equilibrium(
Marginal(
Benefits output( delivered(
Social(Cost(
£s by(a(free$market is(
(MSC)
at(Q1 where(MPB(=(
MPC(and(it(is(
P2 allocatively$
Marginal( inefficient.
Private(Cost(
P1 (MPC)

Note We(assume(here(
If(MSC(pivots( that(there(are(no(
away(from( externalities(from(
MPC(then(the( consumption,(
marginal$ therefore(
Marginal(
external$cost$ MSB=MPB
Private(Benefit(
of$extra$
(MPB)
output$is(
increasing Q2 Q1 Output/Quantity

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Showing the welfare loss from negative externalities
The (deadweight) welfare loss refers to the total value of the undesired impact of negative externalities, as a
result of the over-production occurring in this market.

Costs,(
Marginal(
Benefits
Social(Cost
£s

P2 This(is(the(area(of(
Marginal( social'welfare'loss'
Private(Cost because(the(
P1
market(output( (Q1)(
supplied(is(higher(
than(the(social(
optimum(position(
Note (Q2)
The(
deadweight' Marginal(
loss'of'social' Private(Benefit
welfare'
happens(when(
MSC(>(MPC( Q2 Q1 Output/Quantity

Common error alert!

Students frequently draw the welfare loss triangle in the wrong place! One piece of advice is to put your pencil
on the free market equilibrium and then draw a vertical line in whichever direction you can to create a triangle.

A second piece of advice is that the triangle always creates an ‘arrow’ that points towards the desired socially
optimal equilibrium.

Negative consumption externalities

Negative consumption externalities arise in the case of smoking, alcohol, unhealthy foods and so on. These
would be shown on the demand curve as below. These are also examples of demerit goods, discussed below,
but it is important to recognise that not all goods or services associated with negative consumption
externalities are necessarily demerit goods.

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Positive externalities
Positive externalities exist when third parties benefit from the spill-over effects of production/consumption e.g.
the social returns from investment in training or the positive benefits from health care/medical research.

• Private benefits are the benefits faced by the producer or consumer directly involved in a transaction
• External benefits are the benefits enjoyed by third parties as a result of a transaction that they are not
directly involved in (note - “external benefits” is a synonym for positive externalities)
• Social benefit = private benefits plus external benefits
• Therefore, when positive (consumption) externalities exist, social benefits exceed private benefits
• External benefits occur when the activity of one agent has a positive effect on the wellbeing of a third
party
• External benefits are good for third parties, but the consumer and producer don’t take this into
account, meaning that output will be too low. In the case of positive consumption externalities, the
market price will therefore be too high
Additional key terms that are needed for understanding positive consumption externalities are:

• Marginal private benefit (MPB): benefit to the consumer of consuming an additional unit of output
• Marginal external benefit (MEB): benefit to third parties from the consumption of an additional unit
of output
• Marginal social benefit (MSB): total benefit to society of consuming an extra unit of output. MSB =
MPB + MEB
• With positive (consumption) externalities, marginal social benefit is higher than marginal private
benefit

Analysis diagram of positive externalities from consumption

• If there are positive externalities, then we must add the external benefits to the demand curve (i.e. the
marginal private benefit (MPB) curve) to find the marginal social benefit curve (MSB)
• If the market fails to include these external benefits, the private equilibrium output is Q1 and the price
P1 where marginal private cost = marginal private benefit
• In a free market, there is under-consumption of this good or service
• The socially efficient output would be Q2 with a higher price P2. At this output level, the external
benefits have been considered, and marginal social cost is equal to marginal social benefit

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 This&is&the&area&of&social'welfare'loss'
Costs,&Benefits because&the&market&output& Q1&is&lower&
£s than&the&socially&efficient&level
Marginal&
Private&Cost

P2

P1
Marginal&Social&
Benefit

If&the&market&
price&ignores&
positive& Social&optimum&position& Marginal&Private&
externalities,& is&output& Q2&whereas&the& Benefit
there&will&be& market&equilibrium&is&Q1
underF
consumption Q1 Q2 Output/Quantity

Examples of positive consumption externalities

Health Early years Subsidised Bike Public libraries / Museums and Free school
programmes education e.g. Schemes in community Galleries meals /
e.g. HNS nursery urban areas spaces nutritional
services provision advice

Note that it is also possible to consider positive externalities in production (rather than consumption, as we’ve
done so far). For positive production externalities, the marginal social cost of production is less than the
marginal private cost of production. A good example arises from universities making their research available
as a public good. Positive production externalities shift the supply curve to the right.

Mixed externalities - net social welfare loss or social welfare gain

Consider the diagram below – there are both negative production externalities and positive consumption
externalities! However, overall, there are net social costs in this market i.e. it is costing society more to produce
these units than society is valuing these units. The socially optimal equilibrium occurs where MSC = MSB, and
the private market equilibrium where MPC = MPB. As a result, the social optimum output is lower than the
free market equilibrium output.

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 Benefit,
Social optimum is There are net social
Cost
where MSB = MSC
MSC costs in this market
i.e. it is costing
society more to
produce these units
MPC than society is
B valuing these units.

As a result, the
A social optimum
MSB output is lower than
the free market
MPB equilibrium output.
A: Where MPB=MPC
B: Where MSB = MSC Q2 Q1 Output/Quantity

In the next diagram, there are net social benefits from producing and consuming the product. This is because
there are substantial external benefits from consumption. The free market mechanism might under-provide
this product again leading to market failure.

Benefit,
Social optimum is In this example, there
Cost
where MSB = MSC
are net social benefits
from producing and
consuming the
MSC product. This is
MPC because there are
B
substantial external
benefits from
consumption.
A
MSB
The free market
mechanism might
under-provide this
MPB product again leading
A: Where MPB=MPC to market failure.
B: Where MSB = MSC Q1 Q2 Output/Quantity

Quick question

How many more examples can you think of for a) negative production externalities and b) positive
consumption externalities?

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Examiner tip

It is an excellent idea when answering exam questions on externalities to make sure that you carefully identify
who the third party is that is being affected by the market. For example, suppose you are given a scenario of
a production process creating atmospheric pollution; instead of just writing that “pollution is a negative
externality” you would be better to write that “people living close to the factory may be inhaling air containing
particles that are likely to make them ill, which may result in them taking time off work and losing income as a
result”.

In an exam situation where externalities are mixed, you could also consider acknowledging this fact but for
simplicity illustrating just one on a diagram. Congestion is a good example of a mixed externality where
analysis is made considerably easier by considering it simply as a production externality.

Externalities and property rights

The reason that the market mechanism cannot solve the market failure of externalities is that externalities lack
property rights and therefore have the characteristics of a public good. The market in externalities is missing.
In the case of pollution for example, if any one individual were to pay the polluters to stop polluting, they
cannot confine the benefit to themselves. Since the benefit is also non-rival, they are better therefore to wait
for someone else to pay the polluter and free-ride. The result is that no one acts. The Coase theorem
discusses situations where the parties to an externality are limited and negotiation costs are small. Here the
market may very well find a solution. With the carbon-trading scheme, polluters are required to accept
property rights over their emissions. This allows a market-based solution to exist.

Externalities and allocative efficiency

Previously the condition for allocative efficiency was P=MC. When there are externalities, the condition
becomes P=MSC. Quite apart from the welfare losses shown in the diagram, markets fail on grounds of
allocative efficiency. Key functions of the price mechanism have broken down. In the case of negative
production externalities, the prices signaled by the market are too low and provide the wrong incentive to
consumers and producers. Consumers have insufficient incentive to ration and producers have an incentive
to allocate too many resources to the market in question.

Examiner tip

Discussing allocative efficiency can be a great way to gain extra credit. It can be tricky to show this on a
diagram. With the diagrams preferred by AQA, it works with production externalities but not for consumption.

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4.1.8.5 Merit and demerit goods

Key specification content:

• The classification of something as a merit or demerit good depends on a value judgement
• Such products may be subject to positive and negative externalities
• These goods also suffer from information failure
• Not all goods with consumption externalities are merit or demerit goods.

Merit goods
Merit goods are goods & services the government feels people will under-consume, and which might be
subsidised or made free. Both the state and the private sector provide merit goods. With merit goods
individuals may not act in their own interest because of imperfect information – i.e. they do not fully
understand the private benefits of their consumption. Information failure is an important aspect of the merit
goods issue. Merit goods can be rival, excludable and rejectable. Consumption of merit goods generates
positive externalities -
where the social benefit exceeds the private benefit. A merit good is a product that society values and judges
that people should have regardless of their ability to pay.

Demerit goods
A demerit good is a product that generates negative externalities in consumption. It is a good for which the
social optimum level of consumption is less than the private level of consumption and which society judges is
undesirable and whose consumption should be restricted irrespective of ability to pay. As before, consumers
may be unaware of the negative externalities
that these goods create – they have imperfect information.

Are e-Cigarettes Demerit goods?

E-cigarettes raise a number of issues. Certainly, there are externalities, but the balance of positive and negative
is difficult to judge. There are also information failures. The information failures associated with merit and
demerit goods is of a particular type – a failure to take adequate account of longer-term costs and benefits
compared with immediate impacts. In this case though, the longer-term consequences are very uncertain.
With the first death now reported, does this shift the balance of argument?

Private costs of e-cigarette consumption External costs of e-cigarette consumption

Cost of starter e-cig packs Vapour from e-cigarettes is dangerous
Cost of liquid-nicotine cartridges Gateway for young people to smoke
Private benefits of e-cigarette consumption External benefits of e-cigarette consumption
Utility from a nicotine hit E-cigarettes help smokers to quit
Less social isolation Reduced health costs to society

Imperfect Information

The diagram below splits out the different characteristics of a demerit good. D is the valuation made by an
individual of marginal utility or marginal private benefit used to assess their willingness to pay. Especially
where benefits and costs are long term, individuals may be irrational in making these assessments. The
“correct” valuation lies at D1. It is important to recognise that this is in part a value judgment. The extent of
the information failure is the distance a. Any number of policies such as conventional campaigns through to
nudges might be used to address this aspect. The distance b represents the externality. Correcting the

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information failure would bring the equilibrium to Q1. Correcting for the externality in addition would achieve
the socially optimal outcome Q2 at price P2.

Examiner tip

Behavioural economics provides compelling reasons why individuals might adopt the irrational behaviour
implicit in the information failure discussed above.

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4.1.8.6 Market imperfections

Key specification content:

• Why imperfect and asymmetric information can lead to market failure
• Why monopoly and monopoly power can lead to market failure
• Why immobility of factors of production can lead to market failure

What is information failure / information gaps?

• Information failure occurs when people have inaccurate, incomplete, uncertain or misunderstood
data and so make potentially ‘wrong’ or sub-optimal choices.
• From pensions to computer games consoles, from investing in the stock market to ignorance about
the consequences of borrowing and debt, all of us suffer from one or more information failures.
• The key issue is whether the information failure is trivial or instead it has a big effect on individuals,
their families and society as a whole.
• There may be a case for the government to intervene in a market in some way if information failures
become serious and persistent.

Causes of information gaps

Imperfect information can be caused by
§ Misunderstanding the true costs/benefits: E.g. the side effects of using tanning salons or painkillers
§ Uncertainty about costs and benefits e.g. should younger workers be buying into pension schemes
when we can only guess at conditions in 40 years’ time?
§ Complex information when buying specialist products
§ Inaccurate or misleading information - persuasive advertising may ‘oversell’ the benefits of a product
leading to more consumption than is optimal. Spam mail can be a cause of misinformation for
consumers.
§ Addiction e.g. drug addicts may be unable to stop consumption of harmful substances
§ Lack of awareness – a good example here is that of tuition fees in Britain – many parents and students
find the system of university finance difficult to understand
§ Habitual purchase – buying goods simply out of habit e.g. reordering the same items in an online
grocery shop because consumers are presented with their ‘favourites’ list when they log on

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Examples of information gaps
In nearly every market we find examples of information gaps. Some of them are shown in the graphic below:

Risks from using tanning Addiction to painkillers & Gaining entry to elite Complexity of pension
salons other drugs degree courses schemes

Uncertain quality of Knowledge of the Cowboy builders or other Tourist Bazaars or buying
second hand products nutritional content of “rip-off merchants” and selling antiques
foods

Symmetric and asymmetric Information

• For markets to work, there needs to be symmetric information i.e. consumers & producers have the
same knowledge about products, they know everything there is to know about the effects of
consuming them
• Asymmetric information is when there is an imbalance in information between buyer and seller which
can distort choices

Used vehicles Insider dealing Tenants & landlords

Health insurance Borrowers and lenders Product warranties

Examples of asymmetric information include:

• Landlords who know more about their properties than tenants
o This allows landlords to extract higher rent payments from tenants

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 • Car insurance companies cannot tell the risks associated with selling premiums to each driver – they
have to pool risks and assign premiums to groups of drivers based on assessed risk-factors
o Some very safe drivers may pay higher insurance premiums than they really need to
• Some students have superior knowledge about how to get into the elite / best universities including
which prior courses to take
o This can perpetuate inequality and reduce social mobility
• Doctors have superior knowledge about drugs and treatments
o In a private healthcare system, such as that in the US, this may lead doctors to overprescribe
expensive and sometimes unnecessary treatments
• A used-car seller knows more about vehicle quality than a buyer
o The buyer may pay too much for their car
• Insider information of traders in financial markets
The impact of these gaps is that either an ‘incorrect’ amount is bought and/or the wrong price is paid.

Extension ideas: Moral Hazard and Adverse Selection

Whilst these topics are not on the Edexcel specification, they provide great additional material to get you
thinking! These are two aspects of asymmetric information in insurance markets – moral hazard and adverse
selection.

Moral Hazard
• Moral hazard occurs when insured consumers are likely to take greater risks, knowing that a claim will
be paid for by their cover
• The consumer knows more about his/her intended actions than the producer (insurer)
Adverse Selection
• The adverse selection problem is seen in health insurance
• Those most likely to purchase health insurance are those who are most likely to use it, i.e.
smokers/drinkers/those with chronic health conditions
• The health insurance company knows this and so raises the average price of insurance cover
• This may price some healthy low-risk consumers out of the market, meaning that mainly higher risk
individuals gain insurance – this causes a market failure

Quick question

Think about goods and services you have bought or used today. Are there any in which you think you may
have been affected by an information gap? If so, which goods/services, and why?

Monopoly and monopoly power

As shown on the diagram, the main case against monopolies is that its low price elasticity of demand means
that profits can be increased by restricting output and elevating price. Not only is there a welfare loss but

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allocative efficiency is reduced as price well exceeds marginal cost. The impact may fall particularly on lower
income consumers.

It may be though that the economies of scale experienced by the monopolist more than offset this impact. In
addition, higher profits may allow greater dynamic efficiency gains. In reality, any abuse of monopoly power
may be limited by the actions of the regulatory authorities and competition from international firms.

Factor Immobility

Factor immobility causes market failure because resources are unable to move quickly and without cost in
response to price signals and incentives. Again, one of the functions of the price mechanism has broken
down. Immobile factors of production therefore lead to market failure. There are two broad types:
occupational and geographic immobility.

Occupational immobility
One of the main causes of unemployment is that workers lack the skills required by expanding industries in
the economy. Occupational immobility exists when there are barriers to the mobility of factors of production
between different sectors of the economy, leading to these factors being unemployed or used in ways that
are not efficient.

Some capital inputs are occupationally mobile – a compute can be put to use in many different industries.
And commercial buildings such as shops and offices can be altered to provide a base for many businesses.
However, some units of capital are specific to the industry they have been designed for e.g. a printing press
or a nuclear power station.

People often experience occupational immobility. For example, workers made redundant in the steel industry
or in heavy engineering may find it difficult to find a new job. They may have specific skills that are not
necessarily needed in growing industries which causes a mismatch between the skills on offer from the
unemployed and those required by employers looking for workers. This problem is called structural
unemployment. Clearly this leads to a waste of scarce resources and represents market failure.

Geographical immobility
This refers to barriers to people moving from one area to another to find work. There are good reasons why
geographical immobility might exist:

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 • Family and social ties
• Financial costs of moving home including the costs of selling a house and removal expenses
• Huge regional variations in house prices leading to a shortage of affordable housing in many areas
• High cost of renting property
• Differences in regional cost of living, and between countries
• Migration controls e.g. cap on inward migration
• Cultural and language barriers
• Transport costs

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4.1.8.7 Competition policy

Key specification content:

• The general principles of UK competition policy and some awareness of EU competition policy
• The costs and benefits of such policies
• Examples expected

This section looks at government intervention in markets especially imperfectly competitive markets where
questions and issues of economic efficiency and welfare arising from the conduct and behaviour of businesses
are important.

Competition Policy
The aims of competition policy in countries such as the UK are to promote competition; make markets work
better and contribute towards improved efficiency in individual markets and enhanced competitiveness of
businesses in overseas markets.

Competition policy aims to ensure

• Technological innovation which promotes dynamic efficiency in different markets
• Effective price competition between suppliers
• Safeguard and promote the interests of consumers with more choice and lower prices

The Main Pillars of UK Competition Policy

• Anti-trust & cartels:

o Elimination of agreements that restrict competition including price-fixing by firms who hold
a dominant market position
• Market liberalisation:
o Introducing competition in previously monopolistic sectors such as energy supply, retail
banking, postal services, mobile telecommunications and air transport
• State aid control:
o Policy analyses state aid measures such as airline subsidies to ensure that such measures do
not distort competition in the Single Market
• Merger control:
o Investigation of mergers and take-overs between firms which could result in their dominating
the market

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Examples of anti-competitive behaviour

Price fixing and Predatory pricing Charging excessively Refusal to deal /

market sharing and limit pricing high prices discrimination

Patent misuse Protectionist policies

limiting overseas
trade

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4.1.8.8 Public ownership, privatisation, regulation and deregulation of
markets

Key specification content:

• The arguments for and against
o public ownership of firms and industries
o privatisation
o regulation of markets
o deregulation
• The problem of regulatory capture
• Application of such policies to the UK is expected

Government intervention to control mergers

The Competition and Markets Authority (CMA) is the body given the power to investigate mergers and
takeovers in the UK and consider whether they should go ahead.
1. The CMA has authority to examine mergers if the merged entity has a turnover of £70m or more, or
controls 25% or more of its market
2. They can block an acquisition if they find that the integration of two businesses will lead to a
“significant lessening of competition” in one or more markets at local, regional or national level
3. The aim of the CMA is to ensure that mergers do not lead to worse outcomes for consumers, for
example, through higher prices, lower quality or reduced choice
4. They have the power to give a merger the go-ahead providing certain conditions are met – for
example, the CMA may require the acquiring company to sell off part of its operations to reduce its
market power. For example, the Cineworld / PictureHouse Merger (2013) was eventually cleared by
the CMA after Cineworld sold three cinemas to the Light cinema chain

Recent examples of UK and EU merger policy in action:

• 2019 – the EU Competition Commission blocked the merger of Siemens and Alstom
• 2018 – the CMA investigated and cleared the acquisition by PepsiCo of Pipers Crisps
• 2018 – the CMA started an investigation into the proposed merger between Sainsbury's and Asda
• 2018 – a university laundry merger was broken up by CMA to prevent a lessening of competition
• 2018 – a big merger in the UK energy sector between SSE/Npower was cleared after consultation
• 2017 – the takeover of the wholesaler Booker by retailer Tesco was cleared after an investigation
• 2017 – the CMA cleared Just Eat’s acquisition of HungryHouse in the web-based food delivery market

Examiner tip:
The topic of competition policy is often done poorly by students in exams because they lack useful current
examples – this is an applied topic, and so you need to know examples of interventions, names of the main
industry regulators, etc.

Market in Focus: CMA investigates competition and prices in the UK funeral industry

The Competition and Markets Authority is investigating price inflation in the costs of funerals and crematorium
services. Prices have increased by nearly two thirds over the last decade, many times higher than the increase
in the consumer price index. The CMA is concerned about the lack of competition in what is largely an

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unregulated market and the opportunities for price gouging by some funeral service businesses at a time
when families are distressed. The average price of the basic elements of a funeral is now £4,271 (2018) and the
average cremation fee is £737 (2017). Funeral director prices increased by 68% and crematoria fees rose by
84% over the most recent 10-year period. By comparison, inflation (CPI) increased by around 25% over this
time. The UK funeral industry is fragmented, but there are three sizeable firms: Co-op Funeralcare, Dignity plc,
and Funeral Partners Limited. Dignity is listed on the UK stock market and had a turnover in excess of £300
million in 2017. Co-op has an estimated 16% share of all UK funerals and Dignity around 11%, while Funeral
Partners has a share of just under 2%. Thus, the three firm concentration ratio is 29% - well below the level
required to consider the market an oligopoly. The industry is monopolistically competitive with a large number
of smaller family firms providing differentiated services. But in local areas, monopoly power might be much
greater.

Government intervention to control monopolies

There are a number of ways of controlling the market power of firms within a monopoly or an oligopoly. The
type of intervention depends on the industry e.g. a natural monopoly contrasted with a contestable market
where there is genuine threat of competition from new rival firms.

Intervention Reasoning for the intervention Evaluation

Tax on monopoly A one-off windfall tax on supernormal Risk of tax avoidance / loss of
profits profits for firms with significant market capital investment spending
power
Liberalization of Break up monopolies – allow smaller Smaller businesses may struggle
markets businesses to enter and increased to scale up and compete
contestability
Introduce price Encourages cost efficiency + increases Monopolists may find revenues
capping policies consumer surplus in other ways
Nationalisation Take some monopoly utilities back into Possible loss of productive
public ownership efficiency

Industry regulators
• Regulators are the rule-enforcers
• Regulators are a surrogate for competition
• They are appointed by the government to oversee how a market works and the outcomes in efficiency
and welfare that result for producers and consumers.
• The main competition regulator in the UK is the Competition and Markets Authority (CMA).
• The CMA has responsibility for carrying out investigations into mergers, markets and the regulated
industries and enforcing competition and consumer law.

Water CMA Telecoms & Financial Rail Regulator General Energy

Monopolies Broadcasting Services Markets

Price regulation in markets

Here is an analysis diagram to show the possible impact of a price cap on a firm with market/monopoly power:

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A maximum price involves a normative judgement on behalf of the government / authorities about what that
price should be – it is designed to curb monopoly profit.

P1
MC

Capped
Price
Supernormal Profit AC

C2 C1

Price AR
and
MR
Cost

At a capped price, the monopolist can make Q1 Q2

Output
a profit, but supernormal profit will be lower.

Examiner tip:

Students should be very wary of simply rote-learning diagrams without really understanding them. The very
best candidates in exams are those who are able to adapt the standard diagrams for new / different purposes,
as is the case in the diagram to the left.

Chain of reasoning for capping the price of a monopoly:

To be effective, the A price cap lowers the

capped price must be monopoly May stimulate attempts
set by the regulator (supernormal) profit to improve cost
below the normal profit made by dominants efficiency
maximising price firms in the market

May also lead to the

In theory – it leads to
exit of some businesses
an improvement in
from the industry which
allocative efficiency and
might actually reduce
consumer welfare
competition

Arguments for Price Capping with a Monopoly

1. Capping is an appropriate way to curtail the monopoly power of natural monopolies or dominant
firms preventing them from making excessive profits at the expense of consumers
2. Cuts in the real price levels are good for household and industrial consumers (leading to an increase
in consumer surplus and higher real living standards in the long run).
3. Price capping helps to stimulate improvements in productive efficiency because lower costs are
needed to increase a producer’s profits.

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 4. The price capping system can be a tool for controlling consumer price inflation.

Arguments against Price Capping

1. Price caps have led to large numbers of job losses especially in the utility industries
2. Setting different price capping regimes for each industry distorts the working of the price mechanism
3. The industry regulator may not enough accurate information when setting the price caps for future
years
4. Capping prices means lower profits which in turn can lead to reduced capital investment by the utility
businesses – ultimately consumer suffer if there is under-investment in utility infrastructure such as
water and energy

Examiner tip:

It is vital that you adopt a ‘case by case basis’ approach when considering regulation – there is no standard
way for regulators to regulate or impose restrictions. Regulations can be in the form of price-caps, but can
also be in terms of limits / quotas on production, age restrictions on purchase, health and safety issues, labour
market issues etc. In exam questions, it is a good idea to target the choice of regulation to the specific industry
being considered

Government intervention to promote competition and contestability

Increasing the contestability of markets is an important micro-economic supply-side economic policy.

De-regulation of markets:
• Attempts to liberalise a market to encourage new entrants to act as challengers to established firms
• Deregulation usually involves lowering some of the statutory barriers to entry to reduce the hurdles
for new firms to enter and make at least normal profit
• A good example of deregulation / liberalisation in recent years has been the opening up of the UK
parcels / letters market ending the legal monopoly of the Royal Mail. The Royal Mail has also been
fully privatised after their part privatisation in 2013.
• The UK bus industry was also deregulated nearly thirty years ago and industries such as opticians and
telecoms have also been the subject of deregulation.

Opening up of monopoly networks

A big challenge for intervention in some industries is that the market has some characteristics of a natural
monopoly. This is an industry dominated by one supplier:
• Large economies of scale
o Industry demand is insufficient to exploit all of the economies of scale
o Only one business will reach the minimum efficient scale
• Allocative efficiency and losses
o LRAC is falling over all ranges of output
o If price is set = to MC, economic losses will be made
o It makes sense for the core aspect of the industry to be served by one business

Competition Policy & Natural Monopoly

Encouraging competition in a natural monopoly is difficult – but one approach is to split an industry into the
core network aspect and the final mile service to the consumer.
• Core network service
o Core service e.g. rail network or distribution grids left in the hands of one monopoly business
• The “final mile” service to the consumer
o Possible to introduce competition in other aspects of the industry

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 o E.g. Telecoms companies are allowed to use BT’s infrastructure; franchises are awarded for
rail services

Examples of different types of competition – the UK mail industry

1. Access competition is where the operator collects mail from the customer, sorts it and transports to
Royal Mail's Inward Mail Centres, where it is handed over to Royal Mail, who are paid to deliver it.
Nearly 40% of mail is now covered by access competition
2. End-to-end competition – this is where an operator other than Royal Mail undertakes the entire
process of collecting, sorting and delivering mail to the intended recipients.

Technology and competitive pressures in markets

The Royal Mail is a good example of a business that faces increasing competitive pressures not just from rival
businesses but from substitute competition – some of which are summarised below:
• Retailers and e-retailers
o Amazon own-delivery network (including drones) adds capacity equivalent to a new
operator
o Same day delivery services bought by eBay
o Retailers e.g. Tesco, Asda and others developing in-house Click & Collect / returns service
• Other challenges to Royal Mail volumes and revenues
o E-mail and secure cloud storage – substitutes for handling mail – long term decline in the
volume of addressed letters sent in the UK
o 3D printing at home / business may reduce parcel volumes
o Shift of marketing to social media reduces volumes of direct mail
o Advanced screen technology and e-cards / biometrics cuts the need for banks to send out
new cards

Market in Focus: Contestability in the UK Courier Industry

The UK postal and courier market underwent dramatic changes some years ago when the industry was opened
up to full competition. A number of businesses now offer a UK-wide parcel delivery service. These include
Amazon Logistics, DHL, DPD, FedEx, Hermes, Royal Mail’s Parcelforce, TNT, UK Mail, UPS and Yodel. Intense
competition between service providers has led to a reduction in the average price for each parcel delivered.
Ofcom reported that in 2017 the average unit revenue for a domestic parcel had fallen since 2016 from £3.39
to £3.21.

Potential advantages of de-regulation of markets

1. Where deregulation and market liberalisation break down barriers to entry, market supply should
expand, bringing down prices for consumers.
2. Increased competition and heightened contestability is strongly associated with improved productive
efficiency, allocative efficiency and dynamic efficiency:
3. Competition limits firms’ ability to restrict output and raise prices. By forcing firms to charge a price
closer to marginal cost, allocative efficiency is improved.
4. If firms have less pricing power they are more likely to seek profitability through cost reduction,
boosting productive efficiency and reducing x-inefficiency.
5. Greater capital investment and productivity could lead to improved dynamic efficiency.

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Privatisation

Regional Water Eurostar (UK

Royal Mail Tote Betting
Utilities Government Stake)

Arguments for privatisation:

1. Private companies have a profit incentive to cut costs and be more efficient and raise productivity
2. Government gains revenue from the sale of assets
3. If a state monopoly is replaced by a number of firms this will lead to lower prices. The competitiveness
of the macro economy may also improve
4. Privatisation can create a shareholder democracy i.e. greater share ownership

Arguments against privatisation:

1. Social objectives are given less importance
2. Some activities are best run by the state because they are strategic parts of the economy e.g. water
supply, steel and railways
3. Government loses out on dividends from any future profits. Public sector assets often sold too cheaply
4. Shares are often bought / held by large institutions such as pension funds, insurance funds and others

Competitive Tendering and Contracting Out

In recent years there has been strong growth in the number of private sector businesses that are used to
provide public services. For example, the running of prisons and social care homes might be out-sourced by
central and local government to private sector providers often after a tendering or bidding process has been
held. This is known as contracting-out.

Outsourcing providers in the UK

Two well-known examples of businesses that provide outsourcing services are G4S and Serco.
Serco:
• This is a huge service provider: It is the biggest manager of air traffic control towers worldwide; runs
border control services, hospitals, commuter transport in Dubai and London, and even the European
Space Agency.
G4S:
• G4S is the world's 3rd largest private-sector employer. It is one of the UK government’s largest
providers of services such as manned event security, cash transfer and security, monitoring prisoners
and custodial & detention services as part of the justice process.

The case for contracting out

• Opening public services up to competition can save the taxpayer money and reduce a country’s fiscal
deficit
• Private sector businesses may be more likely to achieve productive efficiency improvements and cost
savings – leading to improved value for money.
• Businesses in the private sector might be more innovative, less hierarchical and less prone to suffering
from diseconomies of scale.

Arguments against contracting out

• Businesses bidding to win contracts might sacrifice quality of service as a way of lowering their costs.

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 • Doubts about some employment practices of service companies e.g. low wages, poor conditions.
• Contracting-out / outsourcing requires proper monitoring which itself involves extra spending

Nationalisation

UK Nuclear
Network Rail
Decommissioning Authority

Case for state ownership:

1. Nationalised firms can target social objectives
2. Firms might charge lower prices – not focused on pure profit maximisation / extracting consumer
surplus
3. Natural monopolies in the state sector can achieve economies of scale = gains in productive efficiency
4. Can be used as a vehicle for hitting macroeconomic aims such as keeping inflation under control

Case against state ownership:

1. Absence of shareholder pressure might lead to diseconomies of scale and therefore higher prices
2. Lack of market competition can lead to X-inefficiency
3. Firms may lack an incentive to innovate – leading to a loss of dynamic efficiency
4. Losses of state-owned firms are absorbed by tax payers and can lead to higher budget deficits

Should the UK rail industry be nationalised?

Following privatisation under a Conservative Government in 1993, British Rail was divided into two main parts:
• National rail infrastructure (i.e. the track, signalling, bridges, tunnels, stations and railway depots)
owned, maintained and operated by Network Rail which is a state-owned and "not-for-dividend"
company
• Train operating companies (TOCs) whose trains run on the network – most have multi-year franchises
– except London and Merseyside.

UK Rail Franchises (Selection) in 2018

Route Operator Owner Franchise Start Franchise End
Cross Arriva Deutsche Bahn (Germany) 10 January 2010 09 November
Country 2019
East East Midlands Stagecoach plc. (UK) 11 November 03 March 2018
Midlands Trains 2007
Great First Great First Group plc. (UK) 20 September 31 March 2019
Western Western 2015
West Coast Virgin West Virgin (51%) / Stagecoach (49%) 02 March 1997 28 April 2018
Coast joint venture
South South Eastern Go-Ahead (65), Keolis (35%) Keolis 01 April 2006 23 June 2018
Eastern is French part-state owned
Trains

Arguments for rail nationalisation

1. Rail network is a natural monopoly suited to state control to achieve economies of scale

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 2. Rail fares can be controlled to improve affordability for rail passengers
3. Profits flow direct to the taxpayer rather than to shareholders of private train companies
4. State can direct investment into the network and borrow more cheaply to fund it

Arguments against rail nationalisation

1. Competition on lines is more important than who owns the railways – therefore, allow more operators
2. Private sector firms are more likely to improve dynamic efficiency and avoid X-inefficiencies
3. Possible to regulate more fares on services run by private train operating companies
4. History of state-run railways in the UK (e.g. in 1970s and 1980s) was not always positive

Nationalisation of rail – applying economic efficiency concepts:

• Productive efficiency
o Operating costs e.g. per passenger kilometre travelled
o Operating costs at peak and off-peak times
o Capacity utilisation of the system – using up marginal spare capacity
o Ability to benefit from economies of scale / avoiding diseconomies of scale
• Allocative efficiency
o Ticket pricing – do prices reflect the marginal costs of providing a service?
o Effects of price discrimination on consumer welfare
o Peak and off-peak pricing
• Dynamic efficiency
o Improvements to customer service – Wi-Fi, ticketing systems, apps, refunds
o Reliability and safety of trains, frequency of service, customer service/information

Broader issues in this debate over state v private in the rail industry:
1. A successful UK rail industry is needed to sustain and improve competitiveness / support tourism /
regional economic balance
2. UK rail network is expensive to run – in part a legacy from the Victorian age. Huge investment needs
– unlikely that the private sector can provide sufficient funds
3. Market failure issues are also important e.g. positive externalities from encouraging an increase in
mass transport / reducing traffic congestion, affordable rail and geographical mobility of labour
4. Much of the UK rail industry is already under state control / or direct regulation e.g. nearly half of
fares, Government sets terms of franchises
5. Affordability of rail travel is a major issue although dynamic pricing cuts fares for many segments of
the market (e.g. student rail cards)

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 4.1.8.9 Government intervention in markets

Key specification content:

• The existence of market failure provides an argument for government intervention in markets
• Governments influence the allocation of resources in a variety of ways such as public expenditure,
taxation and regulation, price controls, the extension of property rights and pollution permits
• Governments have a range of objectives and these affect how they intervene in markets
• Students are expected to apply economic models to assess the role of markets and governments
in a variety of situations and evaluate strengths and weaknesses of different methods of
intervention

Laissez faire economics

In a free market system, governments take the view that markets are best suited to allocating scarce resources
and allow the market forces of supply and demand to set prices. The role of the government is mainly to
protect property rights, uphold the rule of law and maintain the value of the currency. Competitive markets
often deliver improvements in allocative, productive and dynamic efficiency. But there are occasions when
they fail – providing a case for intervention.

Government intervention
Government intervention is when the state gets involved in markets and takes action to try to correct market
failure, improve economic efficiency, impact upon the macroeconomic performance of the economy, and/or
change the distribution of income and wealth. The government can use regulations, taxes, subsidies, maximum
and minimum prices to change price signals, better information or direct provision to change resource
allocation. In recent years, several governments have also tried to use interventions designed to create
behavioural nudges to change the behaviour of consumers and businesses.

Type of Market Failure Consequence of Market Failure Example of Government Intervention

State investment in education and
Factor immobility Structural unemployment
training
Failure of market to provide pure Government funded public goods for
Public goods
public goods, free rider problem collective consumption
Negative externalities, and Over consumption of products that Information campaigns, minimum age
demerit goods are ‘bad’ for us / society for consumption, indirect taxes
Positive externalities, and merit Under consumption of products that Subsidies, better information on
goods are ‘good’ for us / society private benefits
Damaging consequences for
Information gaps Statutory information / labelling
consumers from poor choices
Low income families suffer social Taxation and welfare to redistribute
High relative poverty
exclusion, negative externalities income and wealth

Higher prices for consumers cause loss Competition policy, measures to

Monopoly power in a market
of allocative efficiency encourage new firms into a market

Examiner tip

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All markets will fail to a degree. In considering government intervention, it is essential to demonstrate and
evidence that the market failure is significant. This provides a strong argument for intervention of some sort.

A free market economist might argue that the consequences or costs of such action might offset any gain. If
this is the case then this would be an argument against intervention.

Fiscal Policy Intervention

Fiscal policy (the use of government spending and/or taxation – you will meet this topic in more detail in
macroeconomics) can be used to alter the level of demand for different products and the pattern of demand.
• Indirect taxes can be used to raise the price of products with negative externalities designed to
increase the opportunity cost of consumption and thereby shift the market equilibrium towards a
socially optimal level. Remember that the imposition of an indirect tax will cause market supply to
decrease.
• Subsidies to consumers will lower the price of goods with positive externalities. They will boost
consumption and output of products – remember that a subsidy causes an increase in market supply
and leads to a lower equilibrium price
• Tax relief: The government may offer financial assistance such as tax credits for business investment
in research and development. Or a reduction in corporation tax (a tax on company profits) designed
to promote new capital investment and extra employment
• Changes to taxation and welfare payments can be used to influence the overall distribution of income
and wealth – for example higher direct tax rates on rich households or an increase in the value of
welfare benefits for the poor to make the tax and benefit system more progressive

Government Intervention and Stakeholders

A stakeholder is any person or organisation that has an interest in a specific project or policy decision. As an
economist, whenever you are required to discuss the costs and benefits of an example of government
intervention it is worth asking yourself “who are the major stakeholders in this issue?”

• The decisions of government, businesses and other organisations inevitably affect groups within
society. Increasingly, many businesses are taking into account the effects of their actions not just on
the value that such decisions create for shareholders – but also to a broader range of stakeholder
groups.
• Typically, stakeholder issues come into play on major infrastructural projects where a cost benefit
analysis might be undertaken to assess the likely social costs and benefits – it is important to bring as
many stakeholders into the picture as possible – many people might be affected
Examples of stakeholders you might think of bringing into a discussion include:

1. Employees of a business / organisation (who may / may not be members of a union)

2. Communities where a business is located or affected directly by a decision
3. Suppliers to a business (e.g. back down the supply chain)
4. Shareholders and other investors / financiers
5. Creditors (people owed money)
6. Government (and through them – taxpayers)
7. Trade unions (and the workers they represent)
8. Professional associations
9. NGOs and other advocacy groups (i.e. World Bank, IMF, individual Pressure Groups)
10. Prospective employees
11. Prospective customers

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 12. Local communities
13. National communities
14. International community
15. Competitors within a market

General evaluation on Government Intervention

a) Value judgements: Be aware of the use of ‘value judgements’ in discussions about government
intervention – many people want intervention because of their own vested interests.
b) Changing prices to change incentives and behaviour: Many interventions work though the price
mechanism by changing the relative prices / relative costs of day-to-day decisions
a. E.g. raising the price of fuel to curb consumption
b. Offering a subsidy to bio-fuel producers
c. Using tariffs to change the relative prices of imports in a domestic economy
c) Social science: Economics is a social science and the effects of intervention cannot be calibrated /
forecast with great accuracy – people’s behaviour is subject to change – remember the ‘law of
unintended consequences’!
d) Combinations of policies: One single intervention is unlikely to produce a solution to deep-rooted
economic and social problems – try to build a variety of policy options into your discussion e.g.
policies that work on market demand and market supply
e) The power of markets: Is intervention always necessary? Market forces can be powerful in finding
profitable solutions to problems – don’t underestimate the importance of innovation and invention –
government’s rarely have all the answers and the new economics of collaboration offers insights into
the impact that collusive behaviour can have e.g. in fast-tracking ideas linked to reducing carbon
emissions
f) Costs and benefits: You cannot go far wrong in evaluation by trying to identify and discuss the costs
and benefits of government intervention – some of which only become apparent over long time
periods
g) The ‘law of unintended consequences’: Government intervention does not always work in the way in
which it was intended or the way in which economic theory predicts it should. Part of the fascination
of studying Economics is that the “law of unintended consequences” often comes into play – events
can affect a policy, and consumers and businesses rarely behave precisely in the way in which the
government might want!
h) Case-by-case basis: you need to consider each scenario / market failure / example on its own terms.
Just because a particular type of intervention has been successful in a different market does not mean
it will be effective in another case! In other words, be specific to the scenario you are given, rather
than generic.

Judging the Effects of Intervention – A Revision Check List

To help your evaluation of government intervention – it may be helpful to consider these questions:
1. Efficiency of a policy: Does an intervention lead to a better use of scarce resources? E.g. does it
improve allocative, productive and dynamic efficiency? For example - would introducing indirect taxes
on high fat foods be an efficient way of reducing external costs linked to the growing problem of
obesity?
2. Effectiveness of a policy: Which policy is most likely to meet a specific economic or social objective?
For example, which policies are likely to be effective in reducing road congestion?

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 3. Equity effects of intervention: Is a policy thought of as fair or does one group in society gain more
than another? For example, would it be equitable for the government to increase the top rate of
income tax to 50 per cent in to make the distribution of income more equal?
4. Sustainability of a policy: Does a policy reduce the ability of future generations to engage in economic
activity? Inter-generational equity is an important issue in many current policy topics for example
decisions on which sources of energy we rely on in future years.
5. Does the policy need to be used alongside something else?

Examiner tip:

Students should avoid concluding that a particular policy will always tackle a particular type of market failure.
Instead, they should consider the impact of a policy type on a case-by-case basis i.e. subsidies might help
provision of rural bus services which have positive externalities because bus-users are often quite price-
sensitive (low income or elderly households, for example), whereas subsidising healthy fruit and vegetables
which also have positive externalities may be less effective because there is usually a wider choice available
and a more competitive market, which should lead to lower prices anyway. Furthermore, policies rarely work
on their own – it is nearly always better for students to consider possible policy combinations.

Indirect taxation to solve market failures

Earlier in this course companion, you met specific and ad valorem taxes in relation to demand and supply
diagrams. The diagrams below simply apply the two types of indirect tax to two market failure situations. In
each case, the indirect tax has been set such that the socially optimal level of output (Q*) is achieved, and
therefore the government intervention has, in each case, effectively tackled the market failure. In reality, setting
the tax at exactly the ‘right’ amount is virtually impossible because we cannot easily put a value on the
externalities.

Evaluating indirect taxes

The aim of an indirect tax is to internalise a negative externality; in other words, make those directly involved
in the market transaction bear the cost of the externality. However, implementing these taxes is difficult:

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 1. Setting the ‘right’ tax rate e.g. if the monetary value of a negative externality is hard to measure
2. Cost of collection: e.g. road charging requires expensive infrastructure e.g. IT system of billing
3. Price inelastic demand: higher petrol prices via higher indirect taxes has little effect on demand for
fuel, likewise, would a tax on sugar get people to cut their consumption of high-sugar products?
4. Redistribution effects: Indirect taxes are regressive and affect low-income households most (i.e. even
if rich and poor households pay exactly the same amount in tax, it will be a greater proportion of the
income of the poor household)
5. Increased costs: Higher indirect taxes may cause inflation affecting consumers who did not pollute
and international competitiveness if taxes are higher in one country than another
Example: Evaluating the benefits and costs of a sugar tax
The consumption of too much high sugar food and drink can lead to weight gain which can increase the risk
of medical conditions such as type 2 diabetes, heart disease and stroke. In the 2016 Budget, the former
Chancellor of the Exchequer, George Osborne announced the introduction of a levy on soft drinks. The levy
would apply to manufacturers and importers of sugar added soft drinks, to be implemented in April 2018.
There would be exemptions for fruit juices and milk-based drinks and for small producers.

This statistic shows the results of a survey in which respondents were asked how much the price of soft drinks
would have to increase by to discourage them from buying any in the United Kingdom (UK) in 2016.

The average price of a 330ml can of sugary carbonated soft drink is 69p. What price would discourage you
from buying it?

Share of respondents
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

Price increase would not discourage me 16%

50% increase 24%
20% increase 15%
10% increase 13%
5% increase 9%
Current is too much 22%

Arguments in favour of a sugar tax

1. External costs of consuming sugary drinks – a cause of market failure
2. Information failures – people under-estimate the long-term costs of consumption
3. Sugar tax raises revenue – ring-fenced for other projects e.g. to help fund school sports / breakfast
clubs
4. Tax encourages drink manufacturers to re-formulate their drinks and offer healthier alternatives e.g.
in vending machines
Arguments against a sugar tax
1. Might be regressive on lower income families – the tax might be inequitable
2. Other policies might be more effective in cutting consumption
3. People might simply switch to other sugary products – i.e. the tax might be ineffective
4. Risk of lost jobs in pubs and shops that rely heavily on drink sales

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 5. Risk of producers swapping low-calorie sweeteners for sugar, but these could have other detrimental
health effects

Subsidies to solve market failures

Like with indirect taxes, you have already met subsidies in relation to demand and supply diagrams earlier in
this course companion. The diagram that follows shows how they can be used in relation to correcting the
market failure of positive consumption externalities. In this case, the subsidy increases supply by lowering the
Marginal Social Cost, so that the socially optimal quantity Q* is achieved.

Evaluating Government Subsidies

Some evaluation points might include:
• Are subsidies effective in meeting their aims?
o Will they achieve the desired stimulus to demand / consumption?
o Is a subsidy sufficient? Might other incentives be needed? i.e. does something else other than
price need to change as well e.g. improved information for consumers?
• Will a subsidy affect productivity / efficiency?
o Subsidies for investment and research can bring positive spill overs
o But firms may become dependent on state aid / financial assistance, leading to higher
internal production costs and a lack of innovation
• How much does a subsidy cost and who benefits?
o Is a subsidy part self-financing? Will it create more tax revenue?
o Or does a subsidy create an expensive extra burden for taxpayers who may not have
benefitted?
• Does the subsidy help to correct one or more market failure(s)?
o For example – do more people find work with child-care subsidies?

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 o Or does a subsidy lead to undesired / unintended consequences leading to government
failure?

Maximum prices
This is a legally-imposed maximum price (or price ceiling) in a market that suppliers cannot exceed - in an
attempt to prevent the price from rising above a certain level. To be effective a maximum price has to be set
below the existing free market equilibrium price.

Rent controls to Energy Price Caps to Caps on CEO Pay Cap on Mobile
improve affordability control fuel bills /Bonuses in the labour Roaming Charges in
market the EU

Price capping for Cap on interest rates Cap on annual charges Currency pegs e.g. the
regional monopoly charged by pay-day to occupational Hong Kong / US dollar
water companies lenders pension plans

Analysis diagram for a maximum price

Price

Free.Market. Market.Supply
Equilibrium

P1

Max.Price Max.Price.(price.ceiling)

Market.
Demand

Q3 Q1 Q2 Quantity
In the diagram above the free market price is P1. If a maximum price is imposed, quantity supplied contracts
from Q1 to Q3 whilst quantity demanded expands from Q1 to Q2. Therefore, a maximum price drawn beneath
the equilibrium price leads to a disequilibrium with excess demand equal to the quantity Q3-Q2.

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Maximum prices often lead to secondary (unofficial) markets developing because a scarcity of supply means
that some consumers are willing and able to pay above the regulated price. A good example of this might be
a rent ceiling imposed on rented properties in towns and cities.

A maximum price also involves a normative judgement on behalf of the government about what that price
should be

Example: Analysis of a maximum rent on city centre properties:

The diagram below shows how imposing rent controls might lead to a possible shadow market for rented
property

Rent If,quantity,is,restricted,to,Q3,,then,some,consumers,will,be,willing,to,pay,a,
higher,“unofficial,price”,at,P2
Producers,can,extract,extra,consumer,surplus,at,higher,price

P2 Possible,unofficial,
Market,Supply
price,above,the,ceiling

P1

Extracted,
Max,Price Max,Price consumer,
surplus,above,
the,official,price,
ceiling
Market,
Some,rationing( Demand
or(auction(
process(may,be,
needed,if,market,
output,limited,to, Q3 Q1 Q2 Quantity
a,level,of,Q3

Other possible issues with rent controls (i.e. maximum prices on rent) include:

o Lack of incentive by the landlord to properly maintain properties and keep them safe to live
in (e.g. carrying out gas safety checks and fitting safety locks may no longer be affordable)
o It could lead to some landlords leaving the property rental market, which reduces the
available supply of housing, especially for those households unable to afford to buy property
themselves
o Fewer properties will be available (quantity supplied falls from Q1 to Q3) and so some families
may become homeless, which creates other market failures and issues for the economy

Minimum prices
A minimum price is a price floor. It is a legally imposed price floor below which the normal market price cannot
fall. To be effective the minimum price has to be set above the normal equilibrium price.

Minimum prices are most commonly associated with minimum wages in the labour market or guaranteed
price support schemes for farmers or other producers. There is much debate at the moment about introducing
minimum prices for consumers in an attempt to reduce sales of high fat, salt and sugar foods and high calorie
drinks. The UK government introduced a ban on the sale of alcohol below cost price from May 2014. A can of

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average strength lager cannot be sold for less than 41p and a standard bottle of vodka cannot be sold for less
than £9.06.

Litres of alcohol consumed per capita in the United Kingdom from 2002 to 2016
14
11.1 11.3 11.6 11.4 11 11.1
Average litres per head

12 10.8
10.1 10.1 9.9 9.6 9.5 9.5
9.4 9.4
10
8
6
4
2
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Arguments for a minimum price on alcohol sold in supermarkets:

1. Reduces some of the externalities from people pre-loading cheap supermarket alcohol at home
2. In the long term, a minimum price intervention would cut premature deaths, reduce workplace
absenteeism and also reduce the burden of treating chronic illnesses linked to alcoholism. Alcohol is
estimated to cost the NHS over £billion a year and there is an estimated £11 billion annual cost of
alcohol-related crime.
3. Pubs may benefit from higher minimum prices in supermarkets
4. A minimum price might target cheaper, higher-strength drinks often used by younger drinkers
Counter-arguments against using minimum prices for alcohol:
1. Minimum price is a tax on responsible drinkers – this is inequitable
2. Might be better for drinks producers to agree voluntary policies on alcohol price / strength
3. Better to raise alcohol duties which will raise tax revenues to be used for socially-beneficial projects
4. Demand for alcohol among problem-drinkers is likely to be inelastic and, thus, any increase in price
is likely to have little effect upon their consumption
5. Imposing a minimum price will require extra spending on enforcement e.g. across every drinks retailer

Common error alert!

Students often confuse maximum and minimum prices, putting the maximum price above the free market
equilibrium rather than below, and the minimum price below the free market equilibrium rather than above.
Keep practising these diagrams

Examiner tip

Take a look back at the evaluation of specific examples in the previous section (e.g. sugar taxes, maximum
prices on rent and minimum prices on alcohol). Can you see that the points made are very specific to those

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markets? The best way to achieve high evaluation marks is to be as specific as you can, rather than just
reproducing a list of generic evaluation points. Always think carefully about the specific market in question!

Tradable Pollution Permits

Many economists recommend applying the “polluter pays principle” and placing a price on carbon dioxide
and other greenhouse gases. This can be implemented either through a carbon tax (known as a price
instrument) or a cap-and-trade scheme using tradable permits (a so-called quantity instrument). It is the latter
approach (permits) that you need to know about in detail.

Carbon pricing either through emissions trading or a carbon tax is becoming more common in a number of
countries:
• Sweden’s CO2 tax (first introduced in 1991, Euro 137 per tonne)
• European Union emissions trading scheme (ETS) began in 2005 – the UK remains a part of this
• China launched an emissions cap & trade system in 2017
• India (2010) introduced a carbon tax of 50 rupees per tonne of coal produced and imported to India
• Chile (2014) became the first country in South America to impose a climate pollution tax
• South Korea introduced carbon emissions trading in 2015
• Australia repealed its carbon tax in 2014
• 2017 – Alberta (Canada) started a new carbon tax
• 2017 – Iceland announced intention to double their carbon tax
• 2019 – Singapore plans to introduce a carbon tax

What is carbon emissions trading?

• Carbon trading is a form of pollution control that uses the market mechanism to change relative
prices and the incentives of producers and consumers to reduce their carbon emissions.
• The EU Carbon Emissions Trading Scheme is cap-and-trade scheme for carbon dioxide. It operates
in 31 countries (the 28 EU countries, Iceland, Liechtenstein and Norway). It covers the 45% of the EU’s
greenhouse gas emissions that come from energy intensive sectors.
• The tradeable pollution permits scheme sets a decreasing cap (i.e. maximum limit) for CO2 from
energy intensive industries, and then allocates or auctions emissions allowances (permits) which can
be traded on the open market.
• Businesses need to buy enough emissions allowances to cover their CO2 emissions – the higher the
price, the greater the incentive to cut pollution. Increasing the scarcity of carbon permits leads to an
increase in price. This is one reason why the cap is reduced over time – it forces up the price of CO2
(think about this as the impact of a decrease in supply on a market diagram).
• This makes it more expensive for firms to emit carbon which in turn increases the incentive for
investment in low carbon technologies.
• Carbon trading provides a quantity adjustment to the volume of CO2 emissions.

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If the carbon price is high, power generators might decide to shift some investment towards renewable
projects since this will have a lower carbon impact. And smaller businesses might also switch to small-scale
wind and solar schemes to reduce the expenses of buying carbon permits in the market.

The main problem with the EU carbon trading scheme is that the price per tonne of CO2 has been volatile
and, in recent years, extremely low at less than Euro 5 per tonne. This is partly because initially there were
simply too many permits – the cap was set too high. This means that incentives to use renewable energy are
weak and some power companies have gone back to burning imported coal.

Extension idea: the UK Carbon Price Floor

The UK Carbon Price Floor applies to fossil fuels used for electricity generation. The minimum price for carbon
emissions is designed to provide a stable carbon price signal as a way of internalising externalities. In 2014 the
government announced a price floor of £18/tCO2 from 2016-2020

Arguments for a carbon price floor:

1. Reduces risks, and thus costs, of investing in new nuclear capacity
2. Helps to reduce carbon price volatility – sends a clear signal to polluters
3. Makes low carbon electricity more competitive – gives boost to renewables
Disadvantages of a carbon price floor:
1. Better to restrict more tightly the total supply of carbon permits to increase market price
2. A carbon tax is perhaps a more effective alternative and also raises useful tax revenues
3. Price floor might damage international competitiveness e.g. of the UK steel industry compared to
China/Poland and lead to lower exports and lost jobs
Extension idea: carbon taxes
A tax on carbon increases the private cost of emitting carbon – in theory this will cause output to contract
towards the social optimum. It will also raise tax revenues that might be used by the government to fund other
projects or use as a rebate to those affected (e.g. consumers).

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 Benefit,% MPC%
Cost MSC +%tax
B MPC

A
C

MPB=%MSB

Q1 Q2 Quantity%
Over=production supplied
Advantages of a carbon tax
1. A pollution tax internalizes the externality and makes the polluter pay – it is fairly easy to administer,
and the tax is predictable for businesses affected
2. Carbon fee on imported products will help reduce risk of domestic businesses re-locating to avoid
paying a national carbon tax
3. A tax raises extra revenue which can be ear-marked for other uses e.g. research in cleaner energy
4. Might be offsetting tax cuts on employment / child care or tax rebates to lower-income families
Disadvantages of a carbon tax
1. Low price elasticity of demand – the tax may not change behaviour, there might be more effective
alternative policies on offer
2. Risk of higher structural unemployment among workers in carbon intensive sectors such as mining,
oil and gas – renewables employs relatively few people
3. Risk that the burden of new / higher carbon taxes will fall more heavily on lower-income families
4. Might damage the competitiveness of domestic businesses in overseas markets e.g. UK steel industry
complaining about carbon price floor
Overall, comparing the two instruments, most economists favour a carbon tax over tradeable permits. But
public support for carbon taxes, however, is generally low and people tend not to believe that they are
environmentally efficient.

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Government Provision of Public Goods
Should the state both fund and provide public goods? One argument is that the state needs to provide public
goods to help overcome the free-rider problem.
Because (pure) public goods are non-excludable it is difficult to charge people for benefitting once a product
is available. The free rider problem can lead to the non-provision of a good and thus causes market failure.
Free riders have no incentive to reveal what they are willing and able to pay for a public good because they
enjoy a benefit without paying.

Pure public goods are usually provided – perhaps to a basic standard – by the state on the grounds of:
1. Fairness – the (normative) view that everyone should have equitable access to good quality public
goods such as sanitation systems, public service broadcasting, flood defence systems, the rule of law
and open access to justice.
2. Efficiency – collective provision funded through taxation can lead to economies of scale and a more
efficient use of scarce resources.
3. Social welfare – there are positive externalities (social benefits) from good quality public services not
all of which can be measured by a market price
However, there might also be inefficiencies in relying on the state to provide public goods. Those who favour
a smaller role for the government believe that the private sector is more efficient and innovative and that high
government spending on public goods leads in the long run to a rising tax burden which might crowd-out or
hinder the growth of private sector businesses. Technological change is also changing the degree to which
public goods are non-excludable. Not all public goods need providing – think of fireworks displays, for
example. And some can be provided on a local small scale by local organisations able to collect fees. Others
are provided by charitable organisations, for example the RNLI.

Provision of Information

Health warnings Nutritional labelling Gamble aware Industry standards

There are many examples of intervention designed to change the perceived benefits and costs for consumers
when making their choices in markets. These include:

• Compulsory labelling on products (cigarettes)

• Improved nutritional information on food & drinks
• Campaigns to raise awareness of risks of drink-driving
• Gambling addiction awareness campaigns
• Performance league tables for schools & colleges
• Consumer protection laws e.g. refunds of faulty goods
• Guarantees for used products such as second-hand cars
• Industry standards/certification e.g. in building industry
• Requirement for vehicles to have regular MOT tests

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 Quick question
What do you think are the advantages and disadvantages of government intervention via information
provision?

Regulation to correct market failure

Max C02 emissions

Smoking bans Minimum age laws Recycling directives
for vehicles

Speed limits Fishing quotas

Regulation of the behaviour of businesses and consumers is a “command and control” approach to
intervention in a market - backed up by inspection and penalties for non-compliance. You will meet this topic
again in Theme 3, when you study competition policy.

Arguments for regulation as a way of correcting for market failures:

1. Regulations act as a spur for business innovation e.g. to cut the level of carbon emissions
2. Regulations may be more effective if demand is unresponsive to price changes
3. Regulations can be gradually toughened each year – this will help stimulate capital investment
4. They are often straightforward to understand and for businesses to apply e.g. minimum purchase
age for cigarettes, alcohol, lottery tickets etc.
5. Regulations can often be imposed quickly – other policies, such as taxes and subsidies, may take a
long time to be approved by government / parliament

Risks / disadvantages from heavy use of regulation in markets:

1. High cost of enforcement / administration

2. Regulations can lead to unintended consequences / Government failure
3. The cost of meeting regulations can discourage small businesses and also lead to less competition in
markets
4. Policies such as tax can lead to more tax revenue for the government, whereas regulation is usually
just a cost
5. Total bans are rarely justifiable by economic theory (i.e. the socially optimal level of output where
MSC = MSB must be zero or below)
6. Tight / strict regulation can lead to more illegal trade, increasing the time / cost of the police and law-
enforcement agencies

Quick question
Choose one regulation from the graphic above. Can you note down 3 specific advantages and 3 specific
disadvantages of THAT regulation?

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4.1.8.10 Government failure

Key specification content:

• Government failure occurs when government intervention leads to a worse allocation of resources
• Inadequate information, conflicting objectives and administrative cost are possible sources of
government failure as are unintended consequences and market distortions that governments
may create.

What is Government Failure?

• When government intervention in a market leads to a less efficient allocation of resources and
therefore makes a situation worse
• When government intervention to correct market failure leads to a net social welfare loss
• When the costs of government intervention to correct market failure exceed the benefits
• Government failure can happen if a policy decision fails to create enough of an incentive to change
people’s actual behaviour
Government intervention can prove to be ineffective, inequitable and misplaced.

Political self interest / Policy myopia – search for Regulatory Capture Information failures
lobbying “quick fixes”

Disincentive effects High Enforcement / Conflicting Policy Damaging effects of red

Compliance Costs Objectives tape

Cause of government Brief explanation of problem caused Examples of government failure to

failure consider

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 Political self interest Government influenced by Farm support policies, the drinks
influential political lobbying industry, transport lobby
Poor value for money Low productivity / high waste Investment on IT projects in the NHS,
makes government spending less poor record of PFI projects
effective
Policy short-termism Governments are often looking for Road widening to reduce congestion,
a “quick fix” solution for political ASBOs for offenders
purposes
Regulatory capture When a government agency Self-regulation on alcohol prices
operates in favour of producers not campaigning against a minimum price
consumers
Conflicting objectives One policy objective might conflict Minimum carbon price could damage
with another UK competitiveness and possibly cost
jobs
Bureaucracy & red tape Costs of enforcement may hurt Costs of meeting health and safety and
enterprise & incentives environmental laws
Unintended Policies have unanticipated or Smoking ban – led to an increased use
consequences unintended side-effects of outdoor patio heaters

The Law of Unintended Consequences

• Actions of consumers, producers and government always have at least one and often many effects
that are unanticipated or "unintended.”
• Well-intentioned legislation often acts against the interests of those it is intended to serve
• People and businesses find imaginative ways to circumvent new laws
• Shadow markets develop to undermine an official policy e.g. when there is a maximum price cap
• Examples of unintended consequences:
o Bank bail-outs – raises the problem of moral hazard
o Bio-fuel subsidy –may divert production away from food, cause food price inflation and this
hits the poorest in society
o Import tariffs on steel – hits domestic car and construction firms
o Targets for treating patients – contributed to a reduction in the quality of care e.g. the Mid-
Staffordshire General scandal

Minimum Wage Smoking ban Tariffs on steel Price caps on texts Targets for treating
leads to a reduction encouraged causes damager to leads to higher patients might lead
in staff non-wage widespread use of car makers prices for mobile to a lower quality of
benefits patio heaters handsets care

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Regulatory Failure
The actions of regulators may also bring about government failure

Regulators may limit Capping prices might Regulation becomes May lack the powers
innovation in fast- prevent new firms bureaucratic & costly to be truly effective in
growth markets entering a market protecting consumers

Regulator might be Frequent rule

“behind the curve” changes can stifle
with new business investment
technologies
Key points about government failure
1. Free market economists are distrustful of intervention. They believe that the price mechanism should
be given freedom to operate
2. Often, we can accuse the government of policy failure only with the benefit of hindsight
3. Limited information - no government has the resources and information available to it to make fully
informed, objective judgements. That is the nature of politics.
4. Government failure is most likely to occur when decisions are made in the vested interest of special
interest groups, at the expense of other groups (the result is a loss of equity)

Common error alert!

Many students confuse market failure and government failure – always think carefully about what the
question is asking you to consider. Students also often think that just because a policy has downsides then
government failure is inevitable. In the case of environmental market failures, the welfare loss is
considerable. A policy might be associated with considerable costs and still improve welfare overall. It is
highly likely though that some policies might be better than others.

Examiner tip:

Many microeconomic exam essay questions relate to the effectiveness of government intervention to tackle
a particular market failure. An excellent way to push your answer into the very top level of response for
evaluation (AO4) is to consider whether the welfare gain as a result of government intervention is likely to
exceed (or not) the welfare loss as a result of the market failure i.e. will government failure outweigh the
market failure.

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